Figuring Your ETF Option’s Risk/Reward? Remember to Include These 3 Risks
Exchange-traded funds (ETFs) have opened up a world of opportunity for investors and traders. With one transaction, you can gain exposure to an index, sector, commodity, or asset class. And options on ETFs open up even more ways to hedge, speculate, and/or generate income.
And as all options traders know, at the heart of each options trading decision lies the risk/reward assessment—the trade premium, breakeven price, max profit, max risk, as well as the option delta, theta, and the rest of those risk metrics (collectively known as “greeks”). You can (with the help of options software) do the math and quantify the risks and potential payoff.
But there are other risks associated with ETF options that many traders may not be aware of. While these risks don’t in any way preclude trading ETF options, it’s important to know what they are.
There’s always the chance of the “unexpected” event—the one that upsets even the most well-thought-out plan. Because ETF options can be exercised into shares of the underlying ETF—at any time prior to expiration—it opens the door for several unexpected occurrences. The best you can do is to be aware of them before entering any ETF options trades.
And if you happen to trade ETFs based on the S&P 500 Index (SPX), read on, as there’s a way to sidestep these unforeseen risks: Mini-SPX index and Mini-RUT options, which go by the tickers XSP and MRUT.
ETF Options Risk #1: Early Exercise
An ETF option buyer has the right to exercise that option anytime up to and through options expiration.
Say ETF XYZ is trading @ $52 a share. You sell an out-of-the-money (OTM) put at a strike price of 50 and collect $2 in premium. Your breakeven price on the trade is $48 per share for the ETF itself. So, in your mind you’re “good” unless and until the underlying ETF declines to $48 a share. But one day the ETF drops to $49 a share, and for whatever reason a buyer of the 50-strike price put decides to exercise their option.
You receive a notice of assignment. At that point you’re assigned a long, 100-share position in the underlying ETF at $50 a share. You would need $5,000 to fund the cost of the purchase of the underlying position.
This isn’t necessarily a cataclysmic event, but if you’re caught off guard, this type of outcome—and underlying uncertainty—can be disruptive, and it can have both financial and psychological effects on your trading going forward.
ETF Options Risk #2: Settlement and Delivery
If you carry many positions at the same time, it’s important to be aware of the status of them all, especially if you’re trading options on ETFs. Options expire, and if you happen to be short an in-the-money (ITM) option at the time it expires, on the next trading day you’ll automatically find yourself long or short shares of an ETF. This can be nerve-wracking if an ETF is trading right around the price of your short option near expiration.
In some cases, you might consider buying back the short option prior to expiration, even though you may prefer to just (hopefully) let it expire worthless. In the case of assignment, if you don’t have enough cash on hand in your account to complete the purchase, you should be prepared to wire money immediately from an outside source into your brokerage account to cover your obligation.
ETF Options Risk #3: Dividend Risk
Many ETFs pay dividends on a regular basis—often quarterly, like many stocks. While this may be positive for ETF holders, ETF option sellers should be aware of a given option’s “ex-dividend” date before entering into a trade that involves writing ETF options.
Dividends are paid to the owner of record as of the ex-dividend date. So, the owner of an ITM call typically decides whether it’s better to hold a call option (including its extrinsic or “time” value), or instead exercise the call to become the owner of record.
If a call option you’ve sold trades ITM and the dividend exceeds the remaining time value of the option, there’s a strong likelihood that option will be exercised early. If you’re assigned, you’re obligated to deliver shares of the underlying security and pay cash in the amount of the dividend income to the owner of the call.
For the average investor, this sequence of events might be:
- A mild nuisance. If you have plenty of cash in your trading account, you can likely recover and move on.
- A bit of a strategy adjustment. For example, if you hold a covered call position against a stock you own, an assignment means your shares will get called away before the ex-dividend date.
- A major disruption. In a worst-case scenario, you might need to sell shares of something else to raise enough cash, perhaps incurring an unexpected taxable event and possibly the expense and hassle of wiring money from another account in short order.
Consider Broad-Based Index Options to Sidestep Some Risks
One key to trading success is mitigating as many risks as possible. Options on ETFs are a solid choice for many strategies and circumstances, and they can be a pathway to many opportunities. But be aware of the pitfalls that may trip you up.
If you’re looking to trade the stock market as a whole, consider mini index options as an alternative to ETF options. Mini index options may only be exercised at expiration, and ITM options settle in cash—the difference between the strike price and the settlement price of the SPX and RUT to be exact—so you never have to take a position in any underlying ETF. And a mini index contract size and notional exposure mirrors that of a standard 100-share ETF option contract.
Mini index options may afford you the same benefits and notional exposure as ETF options without the potential uncertainty of physical settlement, early exercise, and dividend risk. You might find that sidestepping these uncertainties can help you assess the risk/reward of your options trades with a bit more clarity.
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