More Options With More Options
By Chintan Kotecha, Nitin Saksena, Youssef Brahimi and Benjamin Bowler

Exchange-traded products span a wide range of offerings, including broad style, sector, industry, country, regional and cross-asset benchmarks. A key reason for their popularity is convenience. Because exchange-traded products trade and settle like a stock, there is no additional infrastructure or documentation required. The most popular exchange-traded product is the exchange-traded fund. For the remainder of this piece, for readability and familiarity, we use the term “ETF” to mean exchange-traded fund and to include other exchange-traded products such as exchange-traded notes (ETNs).

Since the credit crisis, with cross-asset correlations rising, there has been increased demand for investments with broader access. As a result, hedge funds and traditional institutional investors increasingly are using ETFs. Common applications include allocating assets, top-down investing, cash flow management, hedging either broadly or tactically within sectors and executing relative value strategies; for example, trading a stock versus its own sector. ETFs offer flexibility, and given that the products trade like ordinary equities, some institutions that are restricted from using traditional derivatives are able to use ETFs.

Along with growth in the ETF market, there has been a similar rise in the use of options on exchange-traded products. The goal of this report is to examine the size, growth and breadth of the ETF options market and then provide examples of options strategies this market now allows. The analysis that follows uses a universe of ETF options whose underlying ETF country of domicile is the United States and that which is traded in U.S. dollars. We exclude ETFs for which the median daily notional option volume to date (Sept. 7) as of 3Q12 is not at least $10 million. The ETFs with options that meet these criteria are in Figure 1, with their respective third-quarter 2012 (to-date) median daily notional volume.

The ETF options market has been growing through the last decade, with offerings now available across a wide range of equity, commodity, fixed-income and currency ETFs. Consequentially, a liquid and broad ETF options market now allows for options strategies such as cross-asset hedging, overwriting or relative value—traditionally placed at the single-stock and index level within equities—to now be applied at a style, sector, industry, country, regional or cross-asset level.

The remainder of this piece is in two parts. We survey the market of options on exchange-traded products, examining the market size, growth and depth. Then, we list and explain examples of strategies that the options market on exchange-traded products now allows.

ETF OPTIONS MARKET SNAPSHOT
Market Size, Growth And Breadth
Market Size And Growth
Over the last year, the total notional traded on ETF options has ranged from approximately $40 billion to $50 billion per day (Figure 2). For perspective, listed S&P 500 index notional option volume ranged from about $80 billion to $95 billion (the largest of all equity indexes globally) per day for the same period.¹ Notably, approximately 85 percent of the total ETF options volume is traded among only four ETFs. These top four most-liquid ETF options are on SPY (S&P 500), IWM (Russell 2000), QQQ (Nasdaq 100) and GLD (gold). ETF options on SPY grew considerably from 2007 to 2011, and currently trade with one-third of the volume of S&P 500 index options. ETF option volume peaked in the third quarter of 2011 at approximately $66 billion in notional per day. ETF options volumes, like those across other asset classes, have been declining over the last year, as markets appear exhausted from ongoing and lengthy global macroeconomic concerns.

Growth in SPY options volume has outpaced the growth of the total volume traded in listed S&P 500 index options, in part because ETF options allow for more accessibility than index options, as they are denominated on a smaller notional.

Market Breadth
A key feature of the ETF market is the accessibility to trade nonequity assets in an equitylike fashion. ETFs allow investors to take views on fixed income, commodities and currencies with the same mechanical and infrastructural simplicity as when taking views on stocks. Similarly, within the ETF options market, investors can now take advantage of the benefits of optionality across a variety of asset classes.

Even though the majority of ETF options volume is concentrated within four ETFs (three are equity funds; the other is gold), there is close to $6 billion of options notional traded per day in the remainder of liquid ETF options (Figure 3). Of the remaining ETF options volume, 75 percent ($4.4 billion) is in equity funds, 11 percent ($671 million) in fixed-income funds, 10 percent ($620 million) in commodity funds and 4 percent ($208 million) in currency funds. In the next section, we take a closer look at size and growth in ETF options within each asset class.

SPY, IWM and QQQ the most liquid ETF options within equities: Options on equity-based ETFs have approximately $36 billion notional traded per day with the SPY (S&P 500), IWM (Russell 2000) and QQQ (Nasdaq 100) making up $32 billion per day (Figure 4). Since its inception in 2005, options on SPY have grown tremendously and are now trading at approximately $26 billion notional per day. This growth can be attributed to the popularity of S&P 500 optionality (a global benchmark for equities), combined with SPY’s minimal tracking error (as its underlying stocks are the largest U.S. companies) to the S&P 500. Within the equity-asset class, the top three volume leaders represent a diverse selection of equities with access to U.S. large- and small-cap stocks (NYSE Arca: SPY and NYSE Arca: IWM) and technology stocks (Nasdaq GM: QQQ).

The remaining equity ETF options outside the top three also represent a diverse array of investments. Liquid ETF options exist within the following categories:

• International equities: MSCI EEM and EAFE, Brazil, China and Mexico
• U.S. large- and midcap stocks: Dow Jones Industrial Average and S&P 400 MidCap
• U.S. sectors: S&P 500 stocks categorized by their GICS² sectors and broader-sector access to real estate, retail, oil, gold stocks, biotech and home builders
• U.S. equity volatility: Options on VXX, the short-term VIX futures ETN
• Levered and inverse products: On a selection of broad-based U.S. equities, U.S. sectors and international equities. Notably, options on levered and inverse products have outsized volume versus open interest relative to other liquid ETF options. The interpretation is that options on these funds are likely used more for intraday speculation.

Options on fixed-income ETFs showing most consistent growth: The options market for fixed-income ETFs is dominated by contracts on the 20+ Year Treasury Bonds (NYSE Arca: TLT) and UltraShort 20+ Year Treasury (NYSE Arca: TBT) ETFs, which currently account for $654 million notional per day. Both TLT and TBT are linked to long-dated U.S. Treasury bonds. Another $18 million notional per day is being traded in options on the iBoxx $ High Yield Corporate Bond ETF (NYSE Arca: HYG).

Options on these fixed-income ETFs have been growing more consistently than ETF options across other assets (Figure 6). While volumes for equity, commodity and currency ETF options are 50-60 percent off their peaks, volumes on fixed-income ETF options are less than 5 percent off theirs.

Euro, Aussie dollar, and yen the most liquid currency ETF options: Currency ETF options are the least traded among the four asset classes, with their current volumes totaling about $208 million in notional per day. The primary currency ETF options traded are on the FXE (euro), FXA (Australian dollar) and FXY (Japanese yen), which is consistent with the most highly traded currency pairs (Figure 7). Among these, the contract on FXE has been a consistent leader and is currently trading $170 million in notional per day. The majority of options flows on currencies is over the counter and on off-listed exchanges, making it harder to access for individual investors. However, ETFs on currencies provide a wider audience access to options on these most commonly traded currency pairs. Like the commodity ETF options market, currencies are also relatively new, with volumes only picking up in the last four years.

ETF Option Applications
Given the breadth of the ETF options market discussed in the prior section, traditional options strategies primarily implemented on single stocks or equity indexes can now be applied simply and efficiently at the equity sector, country or cross-asset level. In particular, we examine how ETF options allow for new opportunities within the following option applications:

• Hedging
• Stock replacement and leverage
• Overwriting and alpha generation
• Relative value trading

Using ETF Options To Hedge
Liquid and well-developed options markets do exist on nonequity asset classes such as commodities, fixed income and currencies. However, the accessibility and standardization of ETF options across assets offers a distinct advantage, particularly for individual investors. Investors can use ETF options to efficiently and simultaneously hedge a wide range of cross-asset views. In the following examples, we show how ETF options can hedge a rise in U.S. Treasury yields, a decline in gold prices or express a view on the euro/USD spot rate.

Example 1: Put Options On TLT To Hedge A Rise In U.S. Treasury Yields
With U.S. Treasury yields hovering at multidecade lows, there is increased speculation and concern surrounding a sharp rally in Treasury rates and an end to the 30-year Treasury bubble. Investors can expect a significant decline in Treasury bond prices in the event of a sharp rate increase. A simple way to take advantage of this decline would be to sell short shares of TLT. This would, however, require putting up margin and would expose investors to uncapped losses should Treasury yields continue their historical declines.

Instead of going short TLT, an investor could purchase put options on TLT at the expectation of a rate increase. A hypothetical comparison of expiry profit and loss of shorting TLT versus purchasing an at-the-money put option on TLT is shown in Figure 8. In this example, TLT is trading at $124 when both positions are initiated. The put option is struck at $124 for an upfront cost of $3.00. At expiry, both positions pay off if TLT declines below $124, with the put option position making $3 less (the upfront premium). If TLT finishes higher than $124, the short position is subject to uncapped losses. However, the put option’s losses are capped to the upfront premium paid. The capped loss in the put option position is attractive if an investor mistimed the Treasury rate increase.

Example 2: A Put Spread Hedge On GLD To Reduce Risk In Being Long Gold
With the increased demand for exposure to gold in the last few years, GLD has been a widely traded ETF, and its options are some of the most liquid among ETF options (the most liquid of all commodities and also higher than some of the largest equity ETF options). Perceived as a “real” asset, investors look to hold gold in times of widespread macroeconomic uncertainty.

An outright position in GLD is subject to the volatility in gold prices. However, the risk to a long position in GLD can be reduced by overlaying a put spread on top of a GLD position. A put spread purchases a near-the-money put and sells a farther-out-of-the-money put with the same maturity. The cost of the near-the-money put is partially offset by selling the farther out-of-the-money put. The near-the-money put provides full downside protection in the underlying. Often though, complete downside protection is too costly, and it is beneficial to sell a farther-out-of-the-money put that caps downside protection, but also decreases premium paid.

The profit and loss at expiry of a hypothetical put spread on GLD is shown in Figure 9. In the example, GLD is at $150 at trade initiation, and the put spread strikes are $146 for the long put and $139 for the short put. The total cost of the put spread in this example is $1.00. We assume this put spread is overlaid on a long GLD position. The put spread will protect holders of GLD from any losses between $146 and $139, while still participating in GLD upside (less the upfront amount paid for the put spread).

Example 3: A Contrarian View On The Euro With Long FXE Call Options
The EUR/USD spot rate has declined as a result of increased risks in the eurozone over the last year and half (Figure 10). During this time, policymakers within the region have been coordinating to ensure the stability of the euro. However, given the risks still outstanding, a contrarian trade would be to go long the EUR/USD spot rate with the idea that the widespread European crisis will be averted.

A contrarian view on the EUR/USD spot rate could be implemented by purchasing FXE outright. However, a long FXE position has full downside exposure should the euro continue to decline. Instead, a call option on FXE would provide a limited-loss way to take advantage of upside in the euro. Figure 11 shows the profit and loss of a hypothetical at-the-money call option on FXE compared with purchasing FXE outright. In this example, we assume FXE is at $124, and the call option purchased is struck at-the-money for a cost of $1.00. If the euro appreciates, the call option participates in the upside (less the amount paid for the call option up front). If the euro continues its decline, however, the losses are limited to the upfront premium.

Stock Replacement And Leverage
Both call and put options offer leverage to their underlying asset and cost a fraction of the underlying security’s price. Despite only paying a portion of the upfront price, the holder of a call (put) option receives the entire upside (downside) above (below) the strike price less the upfront premium paid. Therefore, options offer leverage as they provide the ability to purchase upside (or downside) of a security without paying for the entire cost of the security.

Investors can benefit from the leverage in options through “stock replacement” trades. A stock replacement trade consists of purchasing a call (put) option in place of a long (short) security position. Since the option costs a fraction of the cost of the security, an investor can allocate far less capital to the investment. Investors can then purchase options with higher notionals as a way to get leverage. Additionally, stock replacement strategies can be less risky than outright long/shorts as the position’s maximum loss is limited to the upfront cost of the options.

Example 4: An Investor Underweight Equities Misses A Sharp Equity Rally And Catches Up By Buying Call Options On Equity ETFs
Since the bottom in March 2009, equity markets have had distinct periods of sharp rallies (Figure 12). However, given the risks within equities, many investors have been underweight equities through these rallies. To keep up with benchmarks, investors that missed rallies may need to catch up. One approach is to purchase higher-beta equities with the idea that should the momentum continue, those high-beta names will outperform their equity benchmarks. However, call options on equity ETFs (i.e., SPY, IWM, QQQ) offer another solution to catch up to an equity market rally. With the leverage in options, investors could purchase options on higher notionals, which would outperform should the rally continue.

Figure 13 shows the hypothetical profit and loss of a levered stock replacement trade on SPY compared alongside an investment in SPY. The stock replacement trade is long three at-the-money call options. By levering the notional, the more SPY continues to rally, the greater the stock replacement trade outperforms (thus allowing investors to catch up in a rally). On the downside, the loss is limited to the amount of upfront premium paid. As a reminder, these stock replacement positions required much less upfront capital than an outright purchase of SPY, and also provide downside protection in the case of large declines in SPY.

Overwriting And Alpha Generation
Because options performance is primarily dependent on the performance of the underlying asset, fundamental investors with a directional view have a potential edge. Strategies that sell options also have an advantage, as options generally trade rich to fair value. Option strategies such as overwriting and iron condors can help investors efficiently monetize their directional view and are risk-controlled ways to harvest the excess premium priced into options.

Overwriting as well as iron condor strategies have been well documented, analyzed and implemented within the equity asset class on single-stock and broad-market index options. Now, however, ETF options allow investors access to sectors and across asset classes when applying these strategies.

Example 5: Overwriting Specific Sectors In A Diversified Equity Portfolio
Take, for example, an investor who owns a diversified portfolio of large-cap stocks and is moderately bullish-to-neutral on specific sectors within the portfolio. To enhance yield, the investor decides to sell call options on names in the lower-conviction sector. With ETF options on equity sectors, instead of selling call options on each of the individual stocks, the investor can instead sell a call option on the specific sector ETF.

The current liquidity of options on the Select Sector SPDR ETFs ³ is shown in Figure 14. Options are most liquid in energy and financials, at $291 million and $139 million, respectively, notional traded per day. Open interest on all sectors is in the billions of dollars of notional. Note that volume in technology sector ETF options is lower because the majority of interest in tech optionality is traded through options on QQQ.

ETF options on sectors offer various advantages to selling individual options on a basket of single stocks, such as:

• Depending on the names, there may be limited liquidity on the single stocks versus the ETF sector.
• There is less risk in selling upside on a sector versus a single stock in the event the investor’s view is incorrect.

Example 6: Iron Condor On GLD To Harvest The Richness In Options
Options generally trade rich to fair value due to an embedded risk premium that accounts for unexpected increases in the underlying security’s volatility. Therefore, selling options can be a profitable trade if the underlying does not realize the amount of volatility priced into its options. However, market participants are wary of selling uncovered option positions, particularly in down markets or in times of sharp rallies.

A less risky way to sell options is through a short iron condor strategy. A hypothetical profit and loss chart for a short iron condor strategy is shown in Figure 15. In this example, the position sells 5 percent out-of-the-money call and put options, and then buys back 10 percent out-of-the-money call and put, thereby covering the two short options positions. The trade collects an upfront premium of 3 percent of notional and has a predetermined maximum loss of 2 percent. All options positions have the same maturity.

Short iron condor strategies on equity indexes globally have performed well over the long term. Figure 16 shows the performance of short iron condor strategies on the S&P 500 (U.S.), Euro Stoxx 50 (Europe) and Nikkei (Japan) indexes.

With ETF options, investors can implement iron condor strategies to take advantage of the richness in optionality across various markets, sectors and other asset classes. For example, the performance of a 1M 88/96 106/114 iron condor strategy⁴ on GLD since June 2008 is shown in Figure 17. The annualized return of the systematic GLD short iron condor strategy since June 2008 is 3.3 percent, with a volatility of 7.3 percent giving an information ratio of 0.45.

Example 7: Long Cyclical Sectors, Short Defensive In Reflationary Environments
Historically, cyclical stocks strongly outperform defensive stocks in reflationary environments. To express this in the U.S., an investor could go long NYSE Arca: XLY (discretionary sector ETF) and short NYSE Arca: XLI (industrials sector ETF). However, this trade has uncapped losses in the amount that XLI potentially outperforms XLY. To help mitigate the risk of the relative value trade, an investor alternatively could purchase call options on XLY and sell a call spread on XLI.

This long-call-option/short-call-spread-option pair trade has limited loss, as the long-call option’s maximum downside is the upfront premium, while the short call spread’s losses are capped to the distance between the two call-option strikes. If indeed XLY outperforms XLI, the long-call option would be better than the short-call spread, allowing an investor to capitalize on the relative outperformance but with limited downside risk.

Endnotes
¹The S&P 500 Index options market is the largest in the world in terms of notional volume.
²For a definition of the S&P Global Industry Classification Standard (GICS), please see: http://www.standardandpoors.com/indices/gics/en/us
³Select Sector SPDRs are ETFs that divide the S&P 500 into nine sectors. Together, the nine Select Sector SPDRs represent the S&P 500 as a whole.
⁴Each month this strategy sells a put that is 4 percent out-of-the-money and a call that is 6 percent out of-the-money and then buys back a put that is 12 percent out-of-the-money and a call 14 percent out-of-the-money. All options are held to expiry and the trade is reinitiated each month.

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