Investors who have exposure to a major market index often want to hedge their exposure or speculate on the level of the index over a given time period. Derivative securities and "options as futures" are two ways that investors can engage in either one of these activities. An investor with exposure to a market index can trade futures contracts on that index, or trade options such as calls or puts on index-tracking exchange-traded funds (ETFs). Two examples of index ETFs that have extremely liquid options markets are the SPDR Standard and Poor's (S&P) 500 ETF (NYSEARCA: SPY), which tracks the S&P 500 index, and the PowerShares QQQ ETF (NASDAQGM: QQQ), which tracks the NASDAQ 100 Index. Below is some general information on the types of contracts, and three reasons why ETF options may be the better choice.
General Nature of Futures and Options
A futures contract is a standardized, legal agreement to buy or sell a specific financial security or commodity at a specified price on a specific date, known as the expiration date. Standard futures contracts are issued monthly. For commodities futures, the contract specifications name the quality, quantity, delivery time and location for the underlying raw material. Futures contracts are obligations, and closing out a futures position prior to expiration is slightly more complicated than, for example, buying or selling stocks to close out a stock position. Futures offer investors an unlimited potential gain, but they also have the risk of an unlimited potential loss. In an extreme example of unlimited loss, assume an investor is short an oil contract with a specified price of $50. If the price of oil goes up, the investor will lose money. Since the price can rise infinitely, the investor's loss can also be infinite.
Options contracts are very similar to futures contracts, with one key difference. Options are contracts that give the investor the right, but not the obligation, to buy or sell a specific security at a specific price, called the strike price, on or before a specific expiration date, depending on the option style. There are three major types of options: European, Bermudan and American. These names have nothing to do with geography but rather with how the contracts are settled. European options give investors the right, but not the obligation, to exercise the contract on the expiration date. Bermudan options give investors the right, but not the obligation, to exercise the option on one of many specified dates between contract origination and expiration. American options allow the investor to exercise the option at any time on or before expiration.
Depending on the type of option contract or strategy used, gains may be capped or unlimited, and losses may be capped or unlimited. With long call options, an investor can never lose more than the premium paid for the contract and has the potential for unlimited gains. With a straight put option, an investor can never lose more than the premium paid, and has a maximum profit of the current price of the underlying, less the premium paid. Option combinations result in varying payoff profiles.
The inherent leverage gained from futures and options can vary. Futures options typically have more leverage, but not always. For example, an e-mini S&P futures contract, which has a nominal value of $100,000, can be purchased with an initial deposit of only $4,600, giving the investor nearly a 22x leverage factor. Since margin requirements must be maintained throughout the contract, this large inherent leverage can be extremely risky for investors during volatile markets, as they would have to keep posting more funds to maintain losses.
Options generally have lower leverage amounts, but they can sometimes be quite high. For example, as of June 2, 2016, an investor could purchase one call option on SPY at the 210 strike price for $83. This would give the investor control of 100 shares, or $21,000 worth of SPY. However, even if SPY declined to $50, there would be no margin to post, as the investor's maximum loss would be the premium of $83 paid.
Top 3 Reasons to Use ETF Options
In summary, the first reason to use ETF options is that they are highly liquid and trade like stock, so positions are easier to close than futures positions. Second, given the structure of the contracts and inherent leverage, options are far less volatile and losses can be capped. Third, though not discussed above, futures are straightforward, but many more creative strategies can be implemented with options. Such examples include straddles, strangles and butterflies. If options are available on an index ETF, they are a much safer and smarter bet.