Options on ETFs & ETFs on options
There is a growing demand for options on exchange-traded funds (ETFs) as well as ETFs that deliver options-based strategies. It is the result of the endless pursuit of yield in a period of shrinking volatility along with the long-term trend toward passive investment strategies.
On the latter, it may be fair to point out that movement toward greater investment in passive strategies may be more the product of financial innovation within that space than the more traditional — and frankly tired — debate between passive and active investing. We will delve into that later, but it will be good to remember why ETFs were first created, which was to make investing in certain financial products, strategies and asset classes easier for the retail investor.
The first ETF created was on Standard & Poor’s depositary receipt (SPDR) and it allowed investors to gain access to the S&P 500. Before that, a trader would have had to trade S&P 500 futures, which was something restricted from most registered investment advisors (RIA) and thought to be too risky for the average retail trader; or a trader would have to try to replicate the entire 500-member index with individual stocks.
“The ETF market has grown in leaps and bounds over the last few years because there has been a seismic shift from active management strategies to passive strategies,” says Bill Looney, CBOE Global Client Services, Head of New York (see “ETF options growth,” below). “In 2016 something like $800 billion in assets moved into ETFs — about $500 billion of which where new money flows and $300 billion were out of mutual funds and into ETFs.”
The main factor for that growth is lower fees, which is not surprising. What is surprising perhaps is that it has led to growth in options trading. “A lot of growth in options volume [is] a direct result of that money flow into the underlying ETFs, where customers will seek to hedge, speculate or yield enhance through the use of those options,” Looney says.
He attributes a lot of the options volume growth to premium selling due to the advent of weekly and shorter-term duration options. “Retail customers, RIAs [and] institutional customers seek to sell short-term premium because the yield capture from selling that volatility has proven to be extremely profitable over the last couple of years,” Looney says. “It creates higher risk-adjusted return, higher Sharp Ratios and overall the market has had no significant volatility even where a majority of people have gotten hurt trading those strategies in any meaningful capacity.”
He has also seen an increase in traders selling puts. “This strategy has grown back to be in vogue with the retail and institutional community. It has been quite some time since we’ve seen this strategy being used by such a broad array of market participants. It is a very compelling strategy and it is a very compelling yield,” Looney says.
In recent years, volume has concentrated in a few names; more than 50% of overall options volume occurs in 15 names, of those 15 names, ETF options like SPDRS, IWM, QQQ and EEM are included.
ETFs on options?
While options traders have turned to trading options on ETFs — as mentioned above — the main value of creating ETFs was to allow retail traders to access markets, strategies and asset classes in a simpler fashion.
The Chicago Board Options Exchange (CBOE) has created a series of benchmark indexes that use options strategies to formulate returns. They have licensed ETF issuers such as Wisdom Tree and ProShares to create ETFs based on those benchmarks (see “Put indexes lower volume,” below).
“We are seeing significant interest in these products. Wisdom Tree has licensed the Put Index (PUT) from CBOE, which sells one month at-the-money options on the S&P 500 Index. The asset growth in that is close to $200 million, up significantly in the last 60 to 90 days,” Looney says.
The logic behind PUT is that the ETF sells an at-the-money put and receives a premium. If SPX settles above the put it is out-of-the-money and collects the premium. If SPX falls, you lose the value of the retracement minus the premium it collected. It will reduce losses in a down market, earn money in a flat market and restrict upside to the premium collected (see “PutWrite skinny,” below).
Option writing has always been viewed as a risky strategy, which is why it makes sense to use it through an ETF structure. Recently, with the historically low volatility, more retail investors are looking to sell premium (see “Shrinking vol,” right).
“The strategy is in vogue; it produces substantial returns over a longer period of time and customers that seek S&P exposure coupled with anywhere between a 20% and 30% blend of the Put Write ETF or that strategy creates for them a much higher risk-adjusted return versus being long the S&P,” Looney says. “It is very compelling from that standpoint.”
It provides yield in an environment where it is extremely tough to find and in an asset class not typically used to find yield. Looney expects to see more of these options strategies offered in ETF wrappers. “It is a differentiator. It is impressive when you look at the research and the returns that these products can offer over a period of time. It is not a short-term play, we are not talking about the VXX or some of the levered ETF products linked to volatility assets; those are a different animal,” he says. “But from the standpoint of strategy, generation of yield is easier to achieve in the equity market through the sale of options, given the market’s bull run of the last couple of years because those strategies have really panned out, so investors are seeking a portion of their portfolio dedicated to those strategies.”
Kapil Rathi, senior vice president for options business development at CBOE, says the growth in ETF is a direct result of retail and institutional traders taking a passive approach. That passive approach is becoming more nuanced because of the new products available for issuers to create. Why should a trader, or RIA for that matter, learn the intricacies of options when they can buy a ready-made ETF off of the shelf? “These customers traditionally have not been that open to trading options. The ETF market has been a step up giving exposure to the derivatives by using ETFs as a mechanism,” Rathi says. “It is moving from being passive to more of a structured product where ETF issuers are using options as a tool to provide additional yield. It is going to be great for the options and ETF industry.”
Looney reminds us that options have not been a part of these traders’ or managers’ tool boxes. Their focus is on growing assets. “What an ETF with an option-imbedded strategy does for those customers is it requires no options paperwork and it requires no transactional component, yet they benefit by having a professional money manager manage the transactional component of the options strategy,” Looney says.
“With the creation of the ETFs, it opens our world and the options industry to a significant amount of new customers. If you look at the major wire houses like Morgan Stanley or Merrill Lynch, their financial consultants are not pushing transactional business, they are pushing managed money business. So products like ETFs with options imbedded strategies in them now becomes — pardon the pun — an option for those customers who would otherwise not be able to trade options. That is a huge potential growth factor in the options business as a whole,” he says.
Rathi adds that more than 90% of RIAs are still not open to trade options in their portfolio, but if you present that same return they can generally get by using options in the form of an ETF and all of a sudden it becomes a mainstream product easier for them to understand. “As an RIA I don’t have to sign [paperwork] or understand what a call or put is,” he says.
Options strategy ETFs provide an easy-to-implement tool to professional advisors. “If a roboadvisor was to include an options-based ETF strategy within their offering, or if a wire house portfolio manager that manages an ETF basket includes these products in their mix, the money flow into that product is going to be meaningful,” Looney says. “It is a win-win for all parties. It is a win for end users, it is a win for issuers of ETFs to differentiate their offering and it is a win for CBOE to further educate, promote and advance the uses of our products as well as the benchmark products we have created.”
The active vs. passive myth
Too much is made over the active/passive debate. “What investors are really doing now is finding the proper balance between active versus passive strategies,” Looney says. “It obviously depends on the audience. An institutional customer is going to seek a much higher percentage of active management to justify the fees they are paying the manager versus a retail customer. That being said, the retail customer is getting much more astute about the fees they are paying, especially with the advent of roboadvisors.”
Add that to the bull market environment since the equities bottomed in March 2009, and it has been difficult for the active manager to compete.
“We have seen global correlation levels plummet over the last year; we have seen a significant uptick in the amount of sector rotation, whether it be healthcare into financials, out of technology, into energies, so on and so forth,” Looney says. “We see the market starting to behave in a more normal capacity where sector rotation is a bigger part of investment strategy as well as the mix between large- mid- and small-cap.”
Seeking that balance is difficult because of the central banks, role and the fact that these are moving targets. “That is why you are seeing ETF issuers seek index licensing agreement to differentiate themselves,” Looney says. “To have products available that permit a customer to gain access to more active strategies in somewhat of a passive basket known as an ETF.”
The breadth of index products has altered the active/passive debate because the amount and variety of indexes allows investors to pretty actively manager their portfolio with a diversified basket of passive investments.
“The [word] passive is probably a misnomer, “Rathi says. “With the advent of [trading] tools and education, the retail market is better equipped, more knowledgeable and able to get almost the same — if not better — returns than what an active manager was able to provide them 10 or 15 years ago. I call it more advancement of the industry. The control is shifting more to retail. It is not so much passive versus active strategies, just a new way of trading.”
When traders can create a portfolio of passive investments that capitalize on numerous asset classes and styles, that investor is creating a pretty sophisticated portfolio that in total appears to be more flexible, or active, than the sum of its parts.
Should retail write options?
For many people, the notion that scores of retail investors are embracing options writing strategies is a flashing red warning sign, similar to the anecdote of getting stock tips from your cab driver. But Looney points out that investors have to operate in the environment they are in.
“For people out there worried, they need to be just as worried about their long SPDR position as they do about their short SPDR put position, because if the market does roll over from its current levels, both of those scenarios would be losses for the customers,” Looney says. “If the market did see a sustained rollover, we certainly could see investors seek to use options for hedging purposes as opposed to yield purposes. We very recently have started to see an uptick in trading flows in the VIX options as well as the SPX options that indicate institutional investors are placing trades that would benefit from a market pullback.”
But we have seen several mini spikes in volatility since the last major pull back in 2011. Traders always need to be vigilant. “It seems to be playing into the geopolitical/domestic political environment — with the new administration’s difficulties enacting a policy agenda, the market is growing a bit impatient,” Looney says. “Couple that with the geopolitical factors among Russia, North Korea and the Middle East — they are all contributing to a high level of investor angst.”