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An options-based ETF strategy can generate income, manage risk


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Investors are exposed to greater risk in this time of almost non-existent yields on bonds. Junk bond investors have been pursuing higher income, which is leading to increased interest in junk bonds. Stock investors are worried about market volatility’s impact on their portfolios.

Some investors may find the answer to both of these problems in long-established options strategies that have been used by professional and skilled individuals.

The complexities of executing options — contracts for the prospective sale or purchase of specific stocks during a set time period — makes them inaccessible for most individual investors. However, many options-based, exchange-traded funds are now available. Individuals now have many options to generate income or hedge risk, and can access them all.

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Option-based ETFs are geared to either hedging (protecting investors from losses in a down market), or providing supplemental income to another investment strategy.

When the price of the stocks falls below a certain threshold, shareholders can use put options to hedge. For supplemental income, they often use puts or calls, option contracts giving the owner the right, but not the obligation, to buy a specified amount of an underlying security at a preset  price within a specified time frame.

This category has grown from a small niche to an easily accessible one over the last few years with the introduction of 120 ETFs. As real bond yields (net Income after Inflation) drop below zero, adoption has been swift.

Investors struggle to manage high stock prices while still receiving low rates of return on their bonds are making options-based ETFs more popular. The total inflows into ETFs based on options have reached $8 billion this year. ETFs designed for hedging alone posted inflows totaling about $5 billion for the 12 months ending Aug. 31 — an indication that many shareholders are using these products for risk protection.

These products might seem strange to many investors because they view volatility as synonymous with risk. But well-thought and well-executed strategies for options can help reduce risk.

The risk of losing capital permanently is true. Bonds can be a risk despite their reputation as being safe. Although stocks can be called risk assets due to their volatility, they offer income potential and the possibility of risk reduction.

Some ETFs offer double-digit increases in share price, and some have annual dividend yields that exceed 5%. Even if share prices are low, these ETFs can still provide higher income than high yield (junk) bonds.

However, easy access to options strategies can prove to be a dangerous thing for investors. Failing to fully understand the dynamics of these markets could lead to underestimating risks or choosing products that are not appropriate. Understanding the risks and rewards involved is a good idea before investing.

These products are like all investments. You have to weigh the tradeoffs when evaluating them. As the risk-reward balance is normal, income potential tends to increase while risk protection tends downward.

Global X Nasdaq 100 (estimated at $4.2 billion) Covered Call ETFQYLDThe fund earns income by selling calls, which allow owners to purchase a stock at a fixed price within a specified time period. If the index increases above a threshold, the fund will have to either sell shares or make cash payments to meet these calls.

While the index had risen by 20% as of September 1, the fund was down approximately 9%. Nationalwide Risk-Managed income ETF (NUSI() uses also options on stocks within the Nasdaq 100.

Global X offers two products similar to QYLD, based on other indexes: the S&P 500 (XYLD) and the Russell 2000 (RYLDThis is a. In late August, the firm launched six options-based ETFs.

Options ETFs may buy puts to help put a ceiling on your losses. These can be costly, so buffer ETFs are sometimes called the “buffer”. They sell calls to offset these costs.

This buffer product often guarantees a ceiling on loss for a set period, which is attractive for risk-averse investors. However, these investors need to be aware of the restrictions and the time frame.

Additionally, buffer products can be subject to short-term performance issues due to the high costs associated with hedging. Selling calls are often used to fund these costs. The opportunity cost can limit the potential upside. There is no free lunch.

Simplify US Equity + Downside Convexity eTFSPDCurrent market cap is $283million. Currently, it doesn’t issue call options. The upside can’t be capped. However, there isn’t a floor for losses. (Teeter, totter.) Put options can be overlain on shares in an organization to reduce the risk. S&P 500 IndexETF.

Others products are based on income from regular dividends, options that trade on stocks with high dividends, and other investments.

The Amplify CCWP Enhanced Dividend Income ETF, which is valued at $647 million (see example below)DIVO)This fund holds blue chip stocks. It also writes covered calls about those companies that the managers aren’t expecting to perform well in certain times. This fund generates more income if it is able to predict accurately the stock’s price movement range.

If investors start small and are educated about the benefits and costs of ETFs, they can reap the rewards.

Funds have different structures, goals and objectives. It can be difficult to compare them. It’s not like choosing among index funds for large-cap stock value stocks. Each is very similar.

As always, investors must make investment decisions that meet their own risk tolerances and goals.