ETFs in your portfolio? Find out how ETF options can enhance your portfolio Jason Ayres, DMS Director, R N Croft Financial Group
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Agenda ETFs and Options on ETFs Enhanced Option Income Options for Protection
ETFs and Options on ETFs
What is an Exchange Traded Fund? Diversification of a mutual fund with the liquidity of a stock Contains investments to replicate the performance of market sectors, bonds, commodities or specific indices and/or investment styles The ETF tracks the net asset value of the underlying investments
The Exchange-Traded Fund Market 129,7 milliards $ CA (Right axis) (Left axis) Source : TSX ETF Report Q2 2017 *521 ETFs Q2 2017
How are they structured? Formed through the deposit of securities in the fund Shares in the fund are often representing a fixed amount of the assets Those shares then trade on the Toronto Stock Exchange the same as shares in a listed company
Example Barrick Gold Newmont Mining Franco Nevada Goldcorp Inc Agnico-Eagle Mines Randgold Royal Gold Kinross Gold Anglogold Ashanti Gold Fields Ltd. ishares S&P/TSX Global Gold Index ETF (XGD)
ETF Directory Source: tmxmoney.com > Investor Tools > ETF Directory
ETFs vs. Mutual Funds Exchange-Traded Fund Traded on an exchange Low fees, no penalties Liquid markets with real-time prices Many are options eligible Mutual Fund Through fund company Possible Fees, penalties Buy/sell at end of day on closing Not options eligible
Characteristics of ETFs Liquidity Diversification Transparency Options Eligibility
TFSA / RRSP Eligible Strategies Purchase calls instead of buying a stock/etf Purchase puts instead of short selling stocks/etf Purchase calls to secure the future purchase price of a stock/etf Covered call writing Protective Puts
Options on ETFs
ETF Options Market Source : TSX ETF Report Q2 2017
ETF Options Market From the 521 exchange traded products listed on the Toronto Stock Exchange, there are 54 of them with options listed on the Montreal Exchange. Source : TSX ETF Report Q2 2017 List of options : http://m-x.ca
Covered Call Writing
The Methodology How is covered call writing different from just buying stocks?
Standard Investing How much money will your stock make? How long it is going to take to make money? If you start losing on the investment, do you sell at a loss or do you wait for it to come back? You hope your investment will make you fortune but you really don't know?
Covered Call Portfolio You know how much cash flow you are going to make You know how long it will take you to make your cash flow You are not overly concerned whether the stock goes up or down You are just consistently collecting money
Covered Call Writing You buy or own a stock You get paid upfront for selling the right for a speculator to buy the stock from you: at a specific price over a specific period of time
Covered Call Example Buy 1,000 shares of XGD (Gold Miners ETF) 1,000 x $12.00 per share = $12,000.00 March 2018 $13.00 call: $0.85 Bid (7 months) Sell 10 calls (covered) You collect $850.00 for the obligation to sell the 1,000 shares over in the next 7 months at $13.00 7.08% premium cash flow in 7 months
Covered Calls Why is it safer to invest your money using the Covered Call methodology?
Risk Distribution Standard Investment Profitable Risk STOCK IS UP A LOT STOCK IS UP A LITTLE STOCK STAY THE SAME Option Writing Profitable Lost Opportunity STOCK IS DOWN A LITTLE STOCK IS DOWN A LOT Lost Opportunity
Covered Call Example Buy 1,000 shares of XGD (Gold Miners ETF) 1,000 x $12.00 per share = $12,000.00 March 2018 $13.00 call: $0.85 Bid (7 months) Sell 10 calls (covered) You collect $850.00 for the obligation to sell the 1,000 shares over in the next 7 months at $13.00 7.08% premium cash flow in 7 months
Covered Call Example Share Price $12.00 Strike $13.00 Premium 7.08% STOCK IS UP A LOT STOCK IS UP A LITTLE STOCK STAY THE SAME STOCK IS DOWN A LITTLE Closing Price in 3 months $18.00 $13.00 $12.00 $11.50 Return 15.41% 15.41% 7.08% 2.91% STOCK IS DOWN A LOT $9.00-17.91%* *Long stock investor is down -25.00%
Dividends Receive dividends in addition The only risk is assignment on ex-dividend day if there is no premium left in the option
Covered Calls Over a ten-year period, if the compound return from stocks is 14% or less, a covered call strategy would not only reduce volatility but increase one s return. Long Term Investment Alternatives for Fiduciaries by Dr. Sheen Kassouf, University of California, Irvine
Performance returns of MCWX vs. XIU (Oct. 1998 to Aug. 2017) MCWX 136.60 % XIU 113.40 % Standard deviation 0.77 % 1.15 % Sharpe ratio 178.10 98.20 Better Sharpe ratio: return/risk www.m-x.ca/mcwx Excluding transaction costs
Incremental Covered Call Writing Establish price targets Generating current income from a long-term holdings Loss repair Hedging individual stocks Tax deferral strategy
Options as Protection
Portfolio Theory - Diversification Only widely accepted method of managing risk is diversification Therefore everyone needs to develop a broad based portfolio of stocks The consequence is diluted returns Concentration in just one individual stock is frowned upon as you have too much unique risk
Standard Investing Dilemma When you start making money, when do you take profits? If you start losing on a stock, when do you sell? Do you wait for the investment to come back?
Stop Losses Traditional approach to limiting losses on an investment has always been to put in a stop loss How does a put options differ from a stop loss?
Disadvantages of stop-loss orders Stop-loss orders are at risk to market volatility $20.00 Target $17.00 $15.00 Stop Loss
Morning Gap Slippage $17.00 Purchase Price $15.00 Stop Loss $14.50 Fill Price
Morning Gap Slippage Stop Loss Filled
Protective Put vs. Stop Loss Protective put no volatility stop out risk Protective put guaranteed strike price exit
Why buy Protective Puts? A way of quantifying risk An alternative to stop-loss orders A method of repositioning yourself on long-term holdings
Put Protection Buy 1 put for every 100 shares of stock Put gives you the right, but not the obligation to sell the ETF at the specific price (strike price) over the specific period (expiration)
Protective Puts on XIU Buy 1000 shares of XIU at $22.24 - $22,240.00 Buy 10 December 2017 $22.00 puts at: $0.50/share - $500.00 Insured all risk of loss below $22.00 (4 months) The cost was 2.25% of your investment Investor has 100% of the upside potential with a defined worst case loss
Scenario 1 ETF rises Position: 1,000 XIU @ $22.24 10 DEC 2017 $22 XIU Puts @ $0.50 Over the next 4 months the XIU rises to $24.00 The protective put expires for a $500.00 loss The investor continues to own the ETF as an investment If the investor feels they need more protection, they can buy more
Scenario 2 The ETF falls Position: 1,000 XIU @ $22.24 10 DEC 2017 $22 XIU Puts @ $0.50 Over the next 4 months the XIU declines to $18.00 The protective put has an intrinsic value of $4.00 ($22.00 strike - $18.00 price) The investor has two choices: 1. Exercise and sell the shares at $22.00 2. Sell the put for $4.00 and keep owning the shares
Protection for Locking In Profits Your stock appreciates like expected You want to hold on, but you don t want to lose your profits Buy a protective put to lock in the sale price, while you continue to profit from the upside
Locking In Profits Buy protective put, lock in sale price without cutting off upside $20.00 $17.00 Purchase Price
Risks If you continuously buy expensive protective puts you can experience accumulating losses Adding protective puts at strategic times can be interpreted as market timing or trading, which cannot suit everyone
Summary Allows investor ability to control absolute worst case risk Ability for investors to lock in gains Ability to reposition on a stock/etf that has moved against you
Thank you
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