Exchange Traded Funds (ETFs), similar in many ways to mutual funds, are investment funds traded on stock exchanges.  ETFs track the performance of commodities, bonds, and large indices such as the S&P 500 (SPX), NASDAQ (IXIC) and the Dow Jones (DJI). Much like stocks, ETFs experience price changes throughout the trading day in which they are bought and sold. Fundamentally, the prices of assets traded remain close to, but not always equal to, its net asset value.

Largely attractive due to lower costs, flexibility, minimal capital gains taxes, and leverage for market exposure, ETFs have become popular among investors. With a recent influx of ETF investments, the risks associated can have severe ramifications for the individual investor and financial markets. To mitigate these risks, ETFs can have options written against them as a hedging strategy for speculative investors. (For more, see: Hedging Basics: What Is A Hedge? )

Following the 2008 financial crisis, financial institutions sought alternative investments offering structure, transparency and liquid products.  At face value, ETFs provide investors with a vehicle to meet their demands. Exchange traded funds are classified as open-end funds allowing investors to gain diversified exposure to financial assets ranging from emerging markets to large indexes. ETF shares are created by financial institutions which replicate the market movement of an underlying index.

For example, SPDR funds are a group of ETFs tracking the movement of assets in the S&P 500 (SPX). The sponsor will issue ETF shares to authorized participants in large blocks called creation units. Authorized participants can redeem creation units in the form of the actual security which the ETF encompasses. Individual investors can buy or sell individual shares in the secondary market. Similar to stocks, investors can take a long or short position, purchase on margin, execute stop loss orders and purchase options. (For more, see: Exchange-Traded Funds (ETFs).)

As with most traded funds, there are risks associated with ETFs. ETFs are motivated by a synthetic structure to replicate an underlying index or market sector. When the underlying indexes, such as emerging markets, are volatile and experience large price fluctuations, synthetic replications can lead to large deviations in returns between the ETF and the underlying security. This may lead to less liquid assets and wider initial bid spreads due to increased replication costs. As the ETF industry has grown, increased competition has led to lower management fees at the cost of transparency. (For more, see: Advantages And Disadvantages Of ETFs .)

Similar to stocks, ETF options are an excellent way to manage risk and hedge investments. Options are financial derivatives that represent contracts between two parties.  On or before the expiration of a contract, the contract owner may buy or sell an asset in the underlying market at a specified strike price.  With respect to ETFs, a call option gives the investor the right to buy an ETF at a predetermined strike price with the expectation that the price of the ETF will rise. Conversely, a put option gives the investor the right to sell an ETF at a predetermined strike price. Under this assumption, the investor believes the ETF will decrease in value. When purchasing options the investor is not buying the actual ETF. They are purchasing an asset whose value fluctuates in harmony with the ETF. Adding options to your ETF trading strategy can help minimize risk-related losses.  In particular, covered calls and straddles are option strategies implemented to hedge risk.

Covered Calls

A variety of options strategies can be implemented to cover risks with potential for profits. A cover call is designed to provide downside protection, while offering some capital gains if the underlying asset rises in value. A cover call is an option strategy whereby an investor writes a call option on an asset while simultaneously holding an equivalent amount of the same asset. The premium collected from the call option will generate additional income. If the underlying ETFs value remains flat or declines slightly, the investor keeps the premium and their stock. If prices rise, the investor receives the premium from the call option and assets are sold at the strike price. Cover calls are a popular option strategy for long term investors to generate extra income from a portfolio of stocks. Because of their high liquidity, a cover call option strategy is widely utilized when trading the underlying ETFs. (For more, see: The Basics Of Covered Calls .)

Similar to cover calls, straddles are an option trading strategy to generate additional income in a long position. A straddle is the purchase or sale of a call and put option on the same strike price.  Investors utilizing a straddle strategy assume that the value of the underlying ETF is volatile. As an investor, you want the ETF to increase or decrease in value more than the strike price of the call and put. The risk associated with buying straddles are if the ETF remains relatively flat and you lose the premiums paid on both the call and put. Conversely selling a straddle requires that the ETF remains close to its initial value.  In either case, straddle option trading is a riskier means to hedge risk than cover calls. (For more, see: Profit On Any Price Change With Long Straddles .)

The Bottom Line

ETF options are utilized as an investment to gain market exposure to the performance associated with an index. Typically, these options are used as a means to hedge investments in traditional ETFs. However as an investment on its own, ETF options can protect a portfolio against declines in assets and offer a steady stream of income for long term investors.