Options on ETFs

In short

A friend of mine once asked me why anyone would bother with an option on a fund when they could just own the fund. I told him it was a fair question, and I still think so. If you are holding shares of an ETF, you may have wondered what these contracts could add to your life. An option on an ETF is a contract that gives one side the right, but not the duty, to buy or sell 100 shares of that fund at a set price before a set date. The buyer pays a price, called the premium, and that premium is the most the buyer can lose. The seller takes the premium and takes on the duty if the buyer decides to use the contract. Before you ever place a trade, read the options disclosure document from the Options Clearing Corporation, titled Characteristics and Risks of Standardized Options. Write down your worst case in dollars first. Then ask yourself if you could live with it.

The whole of it

What it is

I once watched a neighbor put a deposit on a used truck so the seller would hold it for a week. If he changed his mind, he lost the deposit and nothing more. If he wanted the truck, he paid the agreed price. That is close to how an option works, and it is a fair picture to carry in your head.

You have probably heard of ETFs, which are funds that hold a basket of investments and trade on an exchange all day like a single stock. An option on an ETF is a standard contract tied to that fund. One contract covers 100 shares. There are two kinds. A call gives the holder the right to buy the shares at a fixed price, called the strike price. A put gives the holder the right to sell the shares at the strike price. Every contract also has an expiration date, after which it stops existing.

Two people sit on the other side of each trade. The buyer pays the premium and owns the right. The seller, who is also called the writer, collects the premium and owes the duty if the buyer uses the contract. Using the contract is called exercising it. Most ETF options in the United States are American style, which means the holder can exercise any time up to expiration. Some index options are European style and can only be exercised at the end. Check which style you are dealing with.

How it works

If you are holding a call, you hope the fund price rises above your strike. Say the strike is 100 dollars and the fund climbs to 110 dollars. Your right to buy at 100 dollars now has real value. If the fund stays below 100 dollars until expiration, the call expires worthless. You lose the premium and no more.

A put works the other way. A put holder hopes the price falls below the strike. Some people buy puts on a fund they own, the way you buy insurance on a house. You pay a small cost now, and you gain protection if the price drops hard.

Sellers have a harder road. A call seller who owns the shares is said to be covered, because the shares are there to hand over. A call seller who does not own the shares is naked, and the possible loss has no ceiling, since a fund price can keep rising. A put seller can lose a great deal too, down to the point where the fund is worth nothing. Brokers will not let just anyone sell options. They ask about your experience and your money, and they assign an approval level. That is not an insult. It is a fence at the edge of a cliff.

Time matters as well. A contract loses a bit of its value each day as expiration gets closer, all else being equal. Traders call this time decay. Buyers work against that clock. Sellers work with it. Price swings matter too. When markets get jumpy, premiums tend to rise, because the chance of a big move is higher.

One more point deserves your attention. Many ETF options are cleared through the Options Clearing Corporation, which stands between buyer and seller. Its job is to make sure each side keeps its promise.

The numbers, and where to find yours

Every contract has a few numbers you should know before you click anything. The first is the strike price. The second is the expiration date. The third is the premium, which is quoted per share. Because one contract covers 100 shares, you multiply the quote by 100 to get your cost. A quote of 2.50 dollars means a cost of 250 dollars, before any commission.

Your broker's option chain shows all of this. It is a table listing every strike and expiration for a given fund. You will see a bid, which is what buyers will pay, and an ask, which is what sellers want. The gap between them is a real cost to you. Look at the open interest too. That is the count of contracts still outstanding. A low count can mean it is hard to get out at a fair price.

Costs do not stop at the premium. Your broker may charge a per contract fee. The fund itself has an expense ratio, which you can read in its prospectus. Taxes are their own subject. The IRS explains how options are treated in Publication 550, Investment Income and Expenses. Rules on gains, losses, and holding periods can be tricky, so read that publication or talk to a tax professional you trust.

If a limit, margin level, or approval rule is set by law or by your broker, look up the current figure yourself. For the pattern day trader rule on small accounts, the minimum equity is the current figure, which the official source publishes each year, as published by FINRA.

A worked example

Let me tell you about a woman named Dolores, who lives in Ohio and keeps things simple. She owns 100 shares of a broad market ETF. The fund trades at 400 dollars a share, so her holding is worth 40,000 dollars. She has read about protection and wants to see what it would cost her.

She looks at the option chain and finds a put with a strike of 380 dollars that expires in three months. The ask is 6.00 dollars per share. She works the math. 6.00 dollars times 100 shares equals 600 dollars. Her broker charges 0.65 dollars per contract, so her total cost is 600.65 dollars. That is the most she can lose on the put.

Now she checks two outcomes. In the first, the fund falls to 340 dollars. Her shares drop by 60 dollars each. That is 60 times 100, or 6,000 dollars of paper loss. The put lets her sell at 380 dollars, so it is worth 380 minus 340, or 40 dollars a share. 40 times 100 equals 4,000 dollars. Her net loss on the pair is 6,000 minus 4,000 plus 600.65, which comes to 2,600.65 dollars. Without the put, she would have lost 6,000 dollars on paper.

In the second outcome, the fund rises to 430 dollars. The put expires worthless. Her shares gained 30 dollars each, or 3,000 dollars. Subtract the 600.65 dollars she paid, and her net gain is 2,399.35 dollars. She paid for peace of mind and did not need it.

Dolores did not decide if the cost was worth it for me. She decided for herself. That is the only way it works. Nothing here is advice to buy anything. It is only the arithmetic.

Where it goes wrong

I have heard plenty of stories from folks who got burned, and they tend to rhyme. The first is size. A contract controls 100 shares, so a small premium can hide a large exposure. People feel safe because the cost looks low. Then the price moves, and the numbers surprise them.

The second is time. A buyer can be right about the direction and still lose, because the move came too late. The contract expired before the fund got where it was supposed to go. That stings. Plain and simple.

The third is selling without a plan. A seller collects a small premium again and again and starts to feel clever. Then one bad week wipes out months of gains. Selling naked calls is the sharpest edge of all.

The fourth is thin trading. If few contracts exist, the bid and ask can sit far apart. You pay more to get in and get less to get out.

The fifth is the quiet one. Some people forget that a contract can be exercised against them. An American style option can be used early. If you sold one, you could wake up owing shares you did not expect to deliver. Know your duties before you sign up for them.

Questions to answer before you leave this page

Have you read Characteristics and Risks of Standardized Options from the Options Clearing Corporation, and did you understand the section on risks? Can you say, in dollars, the most you could lose on the trade you have in mind? Do you know if you are buying or selling, and what each side owes? Does your broker approve you for the strategy, and do you know why that level exists? Have you looked at the bid, the ask, and the open interest, and do they look fair to you? Do you know your expiration date, and what happens to your position the day after it? Have you checked how the IRS treats your gains and losses in Publication 550? And if the worst case came true next week, would your sleep, your bills, and your family be all right?