Fans of exchange-traded funds are, by and large, a pretty risk-averse group. By using ETFs, they're buying bigger chunks of the market, enjoying low fees, and generally riding Wall Street's larger, more stable waves rather than less predictable ripples in individual stocks. More and more, though, active traders are using ETFs to jump in and out of the market. They're also adopting some of Wall Street's tried-and-true risk management strategies to hedge against the market's wilder swings. Below, we look at a few popular hedging strategies that fit nicely with ETFs, including tools like options, sector funds, and one popular and unique instrument, the leveraged ETF.
Let's start with options. Today, options are available on only about 40 percent of exchange-traded funds and exchange-traded notes, although the percentage is higher for most popular equity indexes. Aside from limited availability, options on ETFs operate in much the same way as stocks. A word of caution: Options aren't for everyone. If you're unfamiliar with the concepts, check out options basics from Investopedia, including definitions of some key terms like call options and put options.
Options 1: "Covered call" or buy/write strategies. Among the most common options strategies used by ETF traders, the buy/write strategy works like this: You buy shares of an ETF and then sell (or write) "call options" on the same shares at a higher price (as with stocks, one option is sold in blocks of 100 shares). The buyer of those options agrees to pay a premium to the seller (that's you) for agreeing to sell the shares if the price rises to a predetermined level before the option expires. If the share price rises to the option price before the option expires, you miss any additional gains. On the other hand, if the option expires before the shares hit that trigger or trades below that level, the seller (you again) still keeps the option premium. Richard Romey, president of ETF Portfolio Solutions, says the upside to the strategy is that it's no riskier than owning the underlying ETF and the premium can add a little extra earning power during periods when the market is flat or slightly down. "The ETF doesn't have to go up as much to make a bigger return on your trade because you've got the option premium," he explains. Also, for investors who aren't interested in selling call options themselves but like the protection offered by this strategy, there are several ETFs based on the buy/write model. They track the CBOE BuyWrite Monthly (BXM), an index based on a covered call strategy for the S&P 500. Two of the best-known buy/write ETFs are IQ Investor Advisors' S&P 500 Covered Call Fund and PowerShares' S&P 500 BuyWrite Portfolio.
[For more on guarding the downside, see Investing Basics: How to Protect Yourself With Stop-Loss Orders.]
Options 2: Protective puts. Think of these as insurance. By buying a protective put on every 100 shares of your ETF, you can protect yourself from the worst of a severe slump in your favorite ETF. For example, you could buy 100 shares of the SPDR S&P 500 ETF (symbol SPY) at $91. Then, buy a September put for $3.95 a share (the price as of May 7), at a strike price of $81. That brings your total investment to $94.95 a share. It costs a bit, but that protection limits the downside risk, and you'll know exactly what your possible loss might be. In this case, it's $13.95 a share, or the difference between the option price and the share price plus the cost of the premium.
Options 3: The "naked put." So you want to own an ETF for the longer term but you're worried that a market pullback could be coming soon (and yes, if today's bear market rally fails to turn bullish, that may now be the case). Romey says ETF investors can use naked puts to earn a bit of extra return, especially in volatile markets. The strategy is this: Buy shares at the market price, and buy a naked put option against an ETF at a lower price. With a naked put, you're agreeing to buy more shares of the fund if the index falls below a certain price, but premiums you earn are often higher. Since you're betting on future gains for the index, buying more shares at a lower price makes sense if the put is triggered. And if shares don't fall below that level, you once again collect the extra premium. One caveat: If shares fall below the strike price of the put, you'll have to have enough capital available to buy the agreed-upon number of shares.