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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