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Figure 5 Median notional Volume ($B) 8 7 6 5 4 3 2 1 0 Q2 ’07 Q4 ’07 commodity ETF Options Median notional Volume ($B) Dominated by GLD, commodity ETF options trade $3bn notional/day. Q2 ’08 Q4 ’08 Q2 ’09 Q4 ’09 Q2 ’10 ■ GLD ■ SLV ■ USO ■ UNG Source: BofA Merrill Lynch Global Research Figure 6 Median notional Volume ($B) 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 Q2 ’02 Q2 ’03 Q4 ’04 Source: BofA Merrill Lynch Global Research Q4 ’10 Q2 ’11 ■ AGQ Fixed-income ETF Options Median notional Volume ($B) Options on fixed income ETFs showing most consistent growth. Q3 ’05 Q2 ’06 Q1 ’07 Q4 ’07 Q3 ’08 Q2 ’09 ■ TLT ■ TBT ■ HYG Q1 ’10 Q4 ’10 Q4 ’11 Q3 ’11 Q2 ’12 Q2 ’12 • 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 GICS 2 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 broadbased 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. Dominated by GLD, commodity ETF options trade $3 billion notional/day: Commodity ETF options are the second-most-liquid asset class of ETF options traded, and are dominated by GLD, (gold), which trades approximately $2.4 billion in notional per day (Figure 5). The remaining notional of commodity ETF options is traded primarily through NYSE Arca: SLV (silver), NYSE Arca: USO (oil), NYSE Arca: UNG (natural gas) and NYSE Arca: AGQ (two-times levered silver). Options on commodity ETFs are relatively new and have picked up volume only in the last four years. Macroeconomic factors help explain the demand for options on precious metals and energy. Gold and silver become more valuable when default risks to global central banks’ balance sheets increase. And, recurring tensions in oil-producing countries bring volatility to energy prices. ETF options on these commodities allow investors the opportunity to hedge and/or speculate on these volatile markets. 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 longdated 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 $170 million in notional per day. The majority of options flows on currencies is over the counter and on off-listed exchanges, making it harder to access for individual investors. However, ETFs on currencies provide a wider audience access to options on these most commonly traded currency pairs. Like the commodity ETF options market, currencies are also relatively new, with volumes only picking up in the last four years. ETF Option Applications Given the breadth of the ETF options market discussed in the prior section, traditional options strategies primarily implemented on single stocks or equity indexes can now be applied simply and efficiently at the equity sec- Figure 7 Median notional Volume ($B) 0.5 0.4 0.3 0.2 0.1 0.0 Q2 ’07 Q4 ’07 currency ETF Options Median notional Volume ($B) Euro, Aussie dollar and yen are the most liquid currency ETF options. Q2 ’08 Q4 ’08 Q2 ’09 Q4 ’09 Q2 ’10 ■ FXE ■ FXA ■ FXY Source: BofA Merrill Lynch Global Research Q4 ’10 Q2 ’11 Q4 ’11 Q2 ’12 www.journalofindexes.com November / December 2012 13
Figure 8 Trade Proft & Loss ($) Source: BofA Merrill Lynch Global Research Figure 9 Trade Proft & Loss ($) 30 20 10 0 -10 -20 Hypothetical Expiry P&L Comparison: Short TLT Position Vs. Put Option On TLT -30 100 110 120 130 140 150 Source: BofA Merrill Lynch Global Research ■ TLT Put Option PNL ■ Short TLT PNL Hypothetical Expiry P&L Of Position In GLD Hedged With Put Spread 20 15 10 5 0 -5 -10 -15 -20 -25 -30 125 135 145 155 165 ■ Long GLD ■ Hedged GLD tor, 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 Figure 10 1.60 1.55 1.50 1.45 1.40 1.35 1.30 1.25 1.20 1.15 Dec. ’10 ■ Euro/USD Spot Rate Feb. ’11 Apr. ’11 EUR/USD Spot Rate Jun. ’11 Aug. ’11 Source: BofA Merrill Lynch Global Research Oct. ’11 The EUR/USD spot rate has declined on the back of increased risks in the eurozone. Dec. ’11 Feb. ’12 Apr. ’12 Jun. ’12 Aug. ’12 14 November / December 2012
Page 1 and 2: Plus Blitzer on the history of opti
Page 3: Contributors Mark Abssy Mark Abssy
Page 6 and 7: STOXX LIMITED INNOVATIVE INDEXING.
Page 8 and 9: People’s futures are in your hand
Page 10 and 11: ©2012 Morningstar, Inc. All rights
Page 12 and 13: Exchange-traded products span a wid
Page 16 and 17: the put spread in this example is $
Page 18 and 19: The Loch Ness Monster. Sightings of
Page 20 and 21: TAKE A NEW LINE WITH YOUR EQUITY Po
Page 22 and 23: Over the past 12 years, U.S. invest
Page 24 and 25: Figure 6 $15 $12 $9 $6 $3 5 Indexes
Page 26 and 27: 500 BuyWrite Index (BXM)—was anno
Page 28 and 29: volatility that was about 30 percen
Page 30 and 31: Most investors are familiar with op
Page 32 and 33: equired to establish this position
Page 34 and 35: THE POWERSHARES DB COMMODITY INDEX
Page 36 and 37: Depression was history, rather than
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Page 40 and 41: Alternative Investments 4.0% Real E
Page 42 and 43: tion and management. Within it, an
Page 44 and 45: Much ink has been spilled on the pe
Page 46 and 47: Figure 1 sectors No. of top dogs Re
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Page 50 and 51: States, the average concentration p
Page 52 and 53: Figure 10 sectors Source: Research
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Page 58 and 59: open the Etracs Long-Short S&P 500
Page 60 and 61: Morningstar Index Funds U.S. Style
Page 62 and 63: Exchange-Traded Dow Jones U.S. Indu
Page 64 and 65:
ETF Analytics Your clients want mor
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©2012, THE NASDAQ OMX GROUP, INC.
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Crossword Thinking About Options Te
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