Options-based exchange traded fund strategies may help financial advisors diversify a traditional stock and bond portfolio to meet any challenges ahead.
In the recent webcast, How Options-Based Strategies May Provide Protection, Ben Jones, senior index strategist at Nasdaq, highlighted the importance of the Nasdaq-100 Index as a prominent component in many investors’ tool kits. The benchmark index includes the disruptors, the game-changers, and the forward-thinkers — companies that influence our lives daily in multiple areas. For instance, Apple, Amazon, Google, Facebook, and Microsoft have become global leaders in the technology sector by creating products and services that are essential to both individual consumers and enterprise customers. From software, computing, and communications, to entertainment, advertising, and e-commerce, their platforms represent the new “diversified industrials” of the 21st century.
Jones underscored the importance of disruptive technologies in the growth of the Nasdaq-100. For instance, 58 companies in the Nasdaq-100 (81% of the index’s weight) recently filed patents across one or more of 35 key areas of disruptive technology, including artificial intelligence, clean energy, and blockchain, among others.
“The underlying story for the rise in the Nasdaq-100 is that the U.S.’s economic growth is shifting from capital-intensive, traditional industries — basic materials and oil and gas — to the ‘new-economy’ sectors — technology and consumer services,” Jones said.
While the Nasdaq-100 has helped investors capture growth opportunities over the years, it did not come without its bumps along the way. Consequently, Rohan Reddy, research analyst at Global X ETFs, highlighted ETFs that offer investors exposure to options strategies that are becoming increasingly popular, including covered-call ETFs, buffer ETFs, and tail risk-hedged ETFs.
Covered-call strategies generate income in exchange for upside potential. They gain exposure to stocks in a specific index and sell a call option on that index.
For example, the Global X Nasdaq 100 Covered Call ETF (QYLD) follows the CBOE Nasdaq-100 BuyWrite V2 Index. The ETF offers covered-call exposure to the popular Nasdaq-100 Index (NDX). Suppose you want to maintain exposure to tech and the broader Nasdaq-100. In that case, QYLD is a great vehicle that invests in stocks within the Nasdaq 100 Index and then writes at-the-money Nasdaq index options against the equity portfolio. The options’ premium received will increase with volatility. This can potentially benefit investors, as they will receive a higher monthly dividend and the potential for a higher buffer of protection to the downside in the event of a market sell-off.
Additionally, the Global X Nasdaq 100 Covered Call & Growth ETF (QYLG), which debuted last September, tracks the CBOE Nasdaq-100 Half BuyWrite V2 Index. That may sound like a complex name for an index, but QYLG’s strategy is straightforward. The fund buys the stocks in the Nasdaq 100 and sells “at-the-money” covered calls on approximately 50% of the value of the value of the portfolio of stocks in the same index.
“Covered-call strategies could be valuable in an uncertain environment. Higher volatility tends to increase the options premiums received from selling calls, which can enhance returns even in a trendless market. In addition, covered-call strategies can help diversify an income portfolio away from traditional sources like dividend-paying stocks or fixed income,” Reddy said.
Buffer ETF strategies provide protection against a predetermined amount of losses. They gains exposure to stocks in a specific index, sell an OTM call option, and buy an OTM put option.
For instance, the Global X Nasdaq 100 Collar 95-110 ETF (QCLR) tracks the Nasdaq-100 Quarterly Collar 95-110 Index. QCLR offers a unique approach to NDX by owning the stocks in that venerable index, providing protection by allocating to 5% out-of-the-money (OTM) put options, and generating some income by selling 10% out-of-the-money call options on the same index. That’s an options strategy known as a collar. The ETF employs an asymmetric (net-debit) collar to provide a degree of protection during major market sell-offs in addition to potential volatility reduction.
Designed to assist in risk management, net-debit collars seek to combine a covered call with a protective put. In order to implement a strategy like this correctly, the premiums received from the covered calls must be lower than the costs of the protective puts being purchased. In the Collar 95-110 ETFs, Global X portfolio managers do this by selling 10% “out-of-the-money” covered calls while purchasing protective puts that are 5% “out-of-the-money” every three months. Since the “moneyness” of the covered calls are less than the “moneyness” of the protective puts, the calls are less expensive, resulting in a “net-debit.”
Reddy argued that QCLR is made for investors who are looking to decrease the “noise” in their portfolios with the intention of limiting volatility within a certain range-bound return profile. Investors who are looking to strategically mitigate risk for the long term may want to incorporate a strategy like this to help manage risk. Additionally, it can be used for investors with significant fixed income exposure who are looking to diversify their portfolios without adding substantial risk.
The Global X Nasdaq 100 Risk Managed Income ETF (QRMI) seeks to offer passive investment results that correspond to the underlying index, the Nasdaq-100 Monthly Net Credit Collar 95-100 Index. This index measures the performance of an options collar strategy that is applied to the Nasdaq 100 Index, using a mix of short (sold) call options and long (purchased) put options. The fund employs a net credit collar to provide income and protection against major market sell-offs.
Reddy explained that in income-oriented portfolios, risk-managed income strategies can serve as a diversifier in the alternatives sleeve or by reducing equities exposure. Additionally, income investors are often underweight on technology exposure and may enhance diversification by adding a risk-managed income strategy based on a tech-heavy Nasdaq 100 index.
Lastly, tail risk-hedged strategies provide protection against extreme downside movements. They gain exposure to stocks in a specific index and buy an OTM put option.
The Global X Nasdaq 100 Tail Risk ETF (QTR) seeks to offer passive investment results that correspond to the underlying index, the Nasdaq-100 Quarterly Protective Put 90 Index. This index measures the performance of a protective put strategy that is applied to the underlying stocks of the Nasdaq 100 Index.
Tail risk strategies are subsets of protective put strategies, typically involving the purchase of “out-of-the-money” options with lower strike prices on a specific security or index. For the tail risk strategies, the index approach implemented consists of purchasing the underlying constituents of the reference indexes. Next, the strategies will purchase 10% “out-of-the-money” put options every three months with a goal to put a floor on losses. There is a premium cost when implementing this kind of strategy, and it is expected to underperform its equity indexes in upwards or sideways markets. However, the protection provided may prove useful for investors seeking this kind of strategy.
QTR can be used tactically if an investor is anticipating a major drawdown event but wants to remain invested in any potential upside, according to Reddy. For strategic allocations, it may make sense for investors who are looking for growth characteristics coupled with the potential to mitigate major drawdowns.
Financial advisors who are interested in learning more about an options-based ETF strategy can watch the webcast here on demand.