ETF futures and options are derivative products built on existing exchange-traded funds. Futures represent an agreement to buy or sell shares of an underlying ETF at an agreed-upon price on or before a specified date in the future. Options, on the other hand, give the holder the right, but not the obligation, to trade the underlying ETF shares at an agreed-upon price on or before a specified date in the future.
Derivatives in the ETF market operate the same as an individual equity option or futures contract. These products are typically used to take a speculative bet on the economy, index, or specific sector with less capital outlay.
Breaking Down ETF Futures and Options
ETF futures and options have grown in popularity with the increased adoption of standard exchange-traded funds. These unique products provide the efficiency of a traditional ETF with the flexibility of options trading. By doing so, investors can gain exposure to the performance of an index or sector without committing large amounts of capital.
In addition, options are an excellent tool for hedging against a drawdown in a specific sector or asset classes. Having these mechanisms can enhance a portfolio's return, as investors profit from the movements of an ETF with an added layer of leverage. Getting started with ETF options is logistically the same as traditional options trading. There are standard put and call options traded in blocks of 100 shares in the underlying asset.
ETF futures operate much the same as a normal futures contract. These contracts never take possession of the asset, but keep the capital moving from one basket of futures to another. This means investors don't have direct exposure to the underlying assets and must deal in cash terms. Most ETF futures track the commodity and currency markets, as is the case for normal futures contracts. Commodities invite speculative trades on the future price movements of raw materials used to produce various products.
Risks with ETF Futures and Options
The biggest disadvantage of ETF futures is the contango effect. This occurs when the future price of a commodity exceeds the expected future spot price. In other words, the future spot price is below the current price, and investors are willing to pay more for the commodity in the future than its true value. Furthermore, derivatives like options and futures are dangerous for inexperienced investors. Both products are time-sensitive investments subject to systematic drawdowns, counterparty risk, and price risk.