5.5.1.2. ETF Options
Exchange-traded funds (ETFs) are securities that track a basket of stocks like an index fund but trade on the stock market like an individual stock. An ETF differs from an index in that an index fund is priced on the market’s stated value of the securities that make up the fund, whereas an ETF, like a stock, is priced based on the investors’ perceived value of that basket of funds. Thus, an ETF is priced by supply and demand.
Like an equity option, an ETF option may be traded at any time of day at the market price prevailing at the time of the trade. Also like an equity option, an ETF option is American-style, and it settles in ETF shares, not cash. Like index options, ETF options can be used to hedge systematic risk. If you are worried about a market decline, you can buy a put on an ETF that tracks the market. If you have a portfolio of short positions and are worried the stock market may rise, you can buy a call option on an ETF.
Sample Question 1
Stock index options are used to hedge against:
A. Business risk
B. Currency risk
C. Liquidity risk
D. Systematic risk
Answer: D. Stock index options hedge against the entire market moving in one direction or the other, which describes systematic risk. Business risk involves a single company, liquidity risk relates to not being able to sell the security when you need to, and currency risk is the risk that you will lose money when exchanging your gains from foreign investments into U.S. dollars.
Sample Question 2
Your customer sells one SPX Jan 1,950 put @ 2 when the index is at 1,958. What is the gain or loss if the holder exercises the option when SPX closes at 1,948?
A. $800 gain
B. $400 gain
C. 0
D. $400 loss
Answer: C. The breakeven when selling a put is the strike price minus the premium. In this example, 1,950 – 2 = 1,948. Therefore, your customer breaks even on the transaction.
Sample Question 3
Which