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the put spread in this example is $1.00. We assume this put spread is overlaid on a long GLD position. The put spread will protect holders of GLD from any losses between $146 and $139, while still participating in GLD upside (less the upfront amount paid for the put spread). Example 3: A Contrarian View On The Euro With Long FXE Call Options The EUR/USD spot rate has declined as a result of increased risks in the eurozone over the last year and half (Figure 10). During this time, policymakers within the region have been coordinating to ensure the stability of the euro. However, given the risks still outstanding, a contrarian trade would be to go long the EUR/USD spot rate with the idea that the widespread European crisis will be averted. A contrarian view on the EUR/USD spot rate could be implemented by purchasing FXE outright. However, a long FXE position has full downside exposure should the euro continue to decline. Instead, a call option on FXE would provide a limited-loss way to take advantage of upside in the euro. Figure 11 shows the profit and loss of a hypothetical at-the-money call option on FXE compared with purchasing FXE outright. In this example, we assume FXE is at $124, and the call option purchased is struck at-the-money for a cost of $1.00. If the euro appreciates, the call option participates in the upside (less the amount paid for the call option up front). If the euro continues its decline, however, the losses are limited to the upfront premium. Stock Replacement And Leverage Both call and put options offer leverage to their underlying asset and cost a fraction of the underlying security’s price. Despite only paying a portion of the upfront price, the holder of a call (put) option receives the entire upside (downside) above (below) the strike price less the upfront premium paid. Therefore, options offer leverage as they provide the ability to purchase upside (or downside) of a security without paying for the entire cost of the security. Investors can benefit from the leverage in options through “stock replacement” trades. A stock replacement trade consists of purchasing a call (put) option in place of a long (short) security position. Since the option costs a fraction of the cost of the security, an investor can allocate far less capital to the investment. Investors can then purchase options with higher notionals as a way to get leverage. Additionally, stock replacement strategies can be less risky than outright long/shorts as the position’s maximum loss is limited to the upfront cost of the options. Example 4: An Investor Underweight Equities Misses A Sharp Equity Rally And Catches Up By Buying Call Options On Equity ETFs Since the bottom in March 2009, equity markets have had distinct periods of sharp rallies (Figure 12). However, given the risks within equities, many investors have been underweight equities through these rallies. To keep up with benchmarks, investors that missed rallies may need to catch up. One approach is to purchase higher-beta equities with the idea that Figure 11 Trade Proft & Loss ($) 25 20 15 10 5 0 -5 -10 Source: BofA Merrill Lynch Global Research Figure 12 1500 1400 1300 1200 1100 1000 900 800 700 600 Mar. ’09 Hypothetical Expiry P&L Of Call Option On FXE Vs. Holding FXE Outright -15 115 120 125 130 135 140 145 S&P 500 Performance March 2009 - Sept. 2012 Jun. Sep. Dec. Jun. Sep. Sep. Dec. Jun ’09 ’09 ’09 ’10 ’10 ’10 ’10 ’11 ’11 ’11 ’11 ’12 ’12 ■ S&P 500 Source: BofA Merrill Lynch Global Research Note: Data as of Sept. 7, 2012. ■ ATM Call On FXE ■ Long FXE Since bottoming in 2009, the S&P 500 has had distinct periods of sharp rallies should the momentum continue, those high-beta names will outperform their equity benchmarks. However, call options on equity ETFs (i.e., SPY, IWM, QQQ) offer another solution to catch up to an equity market rally. With the leverage in options, investors could purchase options on higher notionals, which would outperform should the rally continue. Figure 13 shows the hypothetical profit and loss of a levered stock replacement trade on SPY compared alongside an investment in SPY. The stock replacement trade is long three at-the-money call options. By levering the notional, the more SPY continues to rally, the greater the stock replacement trade outperforms (thus allowing investors to catch up in a rally). On the downside, the loss is limited to the amount of upfront premium paid. As a reminder, these stock replacement positions required much less upfront capital than an outright purchase of SPY, and also provide downside protection in the case of large declines in SPY. Overwriting And Alpha Generation Because options performance is primarily dependent on the performance of the underlying asset, fundamental investors with a directional view have a potential edge. Strategies that sell options also have an advantage, as options generally trade rich to fair value. Option strategies such as overwriting and iron condors can help investors efficiently monetize www.journalofindexes.com November / December 2012 15
Figure 13 20% 15% 10% 5% 0% -5% -10% -15% Hypothetical P&L Of Levered Stock Replacement Trade On SPY Vs. Holding SPY Outright Replacing long equity positions with call options can provide leverage and limit losses on the downside. -10% -5% 0% 5% 10% Source: BofA Merrill Lynch Global Research ■ Long 3 SPY ATM Calls ■ Long SPY their directional view and are risk-controlled ways to harvest the excess premium priced into options. Overwriting as well as iron condor strategies have been well documented, analyzed and implemented within the equity asset class on single-stock and broad-market index options. Now, however, ETF options allow investors access to sectors and across asset classes when applying these strategies. Example 5: Overwriting Specific Sectors In A Diversified Equity Portfolio Take, for example, an investor who owns a diversified portfolio of large-cap stocks and is moderately bullish-to-neutral on specific sectors within the portfolio. To enhance yield, the investor decides to sell call options on names in the lowerconviction sector. With ETF options on equity sectors, instead of selling call options on each of the individual stocks, the investor can instead sell a call option on the specific sector ETF. The current liquidity of options on the Select Sector SPDR ETFs 3 is shown in Figure 14. Options are most liquid in energy and financials, at $291 million and $139 million, respectively, notional traded per day. Open interest on all sectors is in the billions of dollars of notional. Note that volume in technology sector ETF options is lower because the majority of interest in tech optionality is traded through options on QQQ. ETF options on sectors offer various advantages to selling individual options on a basket of single stocks, such as: • Depending on the names, there may be limited liquidity on the single stocks versus the ETF sector. • There is less risk in selling upside on a sector versus a single stock in the event the investor’s view is incorrect. If there are numerous names on which upside is to be sold, it becomes simpler from a transactional perspective to sell an option on a handful of ETFs versus a basket of single stocks. Example 6: Iron Condor On GLD To Harvest The Richness In Options Options generally trade rich to fair value due to an embedded risk premium that accounts for unexpected increases in the underlying security’s volatility. Therefore, selling options can be a profitable trade if the underlying does not realize the amount of volatility priced into its options. However, market participants are wary of selling uncovered option positions, particularly in down markets or in times of sharp rallies. A less risky way to sell options is through a short iron condor strategy. A hypothetical profit and loss chart for a short iron condor strategy is shown in Figure 15. In this example, the position sells 5 percent out-of-the-money call and put options, and then buys back 10 percent out-of-themoney call and put, thereby covering the two short options positions. The trade collects an upfront premium of 3 percent of notional and has a predetermined maximum loss of 2 percent. All options positions have the same maturity. Short iron condor strategies on equity indexes globally have performed well over the long term. Figure 16 shows the performance of short iron condor strategies on the S&P 500 (U.S.), Euro Stoxx 50 (Europe) and Nikkei (Japan) indexes. With ETF options, investors can implement iron condor strategies to take advantage of the richness in optionality across various markets, sectors and other asset classes. For example, the performance of a 1M 88/96 106/114 iron condor strategy 4 on GLD since June 2008 is shown in Figure 17. The annualized return of the systematic GLD short iron condor strategy since June 2008 is 3.3 percent, with a volatility of 7.3 percent giving an information ratio of 0.45. Figure 14 Median Daily Notional Volume On S&P 500 Sector ETF Options, Q3-To-Date Ticker Name ETF AUM ($M) Q3 Median Volume ($M) Q3 Median Open Interest ($M) XLE Energy 7,674.9 290.7 6,795.0 XLF Financial 7,204.5 138.6 6,198.9 XLI Industrial 3,395.9 115.0 3,327.3 XLB Materials 2,187.0 47.4 1,904.6 XLV Health Care 4,937.9 36.7 1,421.8 XLK Technology 10,314.3 31.1 1,753.6 XLU Utilities 6,283.9 22.1 1,126.4 XLP Consumer Staples 5,787.9 20.9 1,771.4 XLY Consumer Discretionary 3,296.8 15.2 1,558.8 Source: BofA Merrill Lynch Global Research. Note: Q3-12 data is as of Sept. 7, 2012. 16 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 14 and 15: Figure 5 Median notional Volume ($B
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
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Page 64 and 65: ETF Analytics Your clients want mor
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