JohnSpence

BOSTON (CBS.MW) — Exchange-traded funds have become popular investment options, but a growing part of this market involves options on ETFs themselves.

Institutional investors and traders are active users of ETF options, most often in tandem with index futures strategies. But financial advisers and sophisticated investors also employ these instruments for hedging strategies designed to smooth a portfolio’s unpredictable swings.

ETF options and their underlying ETFs can be used to dampen the risk of an investor’s portfolio, said Steven Schoenfeld, founder of IndexUniverse.com.

Put- and call options are available for 59 ETFs so far, covering about 40 percent of the industry. The first ETF option was launched in 1998 on the MidCap SPDR MDY, +1.10% and trades on the American Stock Exchange.

ETF options trading volume has been rising steadily since the first quarter of 2003, with the exception of last year’s fourth quarter, according to research from Morgan Stanley ETF analyst Deborah Fuhr.

Nasdaq-100 Cubes QQQ, +0.66% dominate ETF options, with 32 million contracts traded in the second quarter of 2004 alone. The technology-heavy stock benchmark accounts for 83 percent of all U.S. listed ETF options volume, Morgan Stanley reports.

Trading strategies

ETF options strategies can hedge or boost returns in a volatile market, but should be used cautiously. Two conservative approaches involve covered calls and protective puts.

Covered calls can be appealing for investors who already own shares in a particular ETF as a way to lock in profits or for downside protection. The strategy provides income in a sideways market, along with some limited downside protection, but those gains are sacrificed if stocks soar quickly.

The most attractive ETF options strategy for individuals would be to write covered calls, or selling a call option on an ETF that is already in one’s portfolio, especially to add income in a trading range, or bearish, market, Schoenfeld said.

With a covered call, the writer (seller) of the option receives cash for agreeing to sell ETF shares at a given price on a future date, but limits any upside above the predetermined strike price.

If the ETF remains flat, the seller of the covered call pockets the premium, or the cost of the initial investment for the buyer of the call. The strategy is less risky than selling uncovered calls because the investor already owns the shares. Uncovered calls are far more speculative, since investors’ losses are multiplied if an ETF rises sharply.

When writing covered calls, the seller receives downside insurance equal to the amount of the option premium, and loses if the ETF falls by a larger amount than the premium.

Investors seeking insurance against sharp ETF declines, but want to hold the shares to avoid negative tax consequences, can purchase covered or protective puts.

A put option on an ETF allows an investor to sell if the share price falls below the strike price. The put typically increases in value if the ETF declines in price. Of course, if the ETF stays flat at the end of the option period, the put expires worthless.

Protective puts are akin to homeowner’s insurance. If all goes well, the homeowner loses the premiums paid over time. If disaster strikes, the protection is worth the cost.

Still, individual investors should avoid these strategies unless they have considerable experience in the options market. Even veteran investors should be aware relying heavily on insurance is an expensive comfort.

Top 10 ETFs by percentage change in options trading volume (quarterly)