How Protective Puts Can Be Used to Hedge Global ETFs
International investors have many different options when looking for exposure to specific countries around the world. Often times, exchange-traded funds (“ETFs”) are the vehicle of choice given their simplicity and built-in diversification. Most investors are familiar with the concept of buying and selling ETFs, but relatively few take advantage of the options available on the funds, which can help add a layer of protection to a portfolios.
In this article, we’ll take a look at how international investors can protect their portfolio using options on international ETFs.
Stock options provide investors with the right or obligation to buy or sell shares of an underlying stock - including ETFs. When buying an option, the investor is purchasing the right to buy (“call option”) or sell (“put option”) shares at a specified price and time in the future. When selling an option, the investor is selling the rights to stock they are obligated to buy (“call option”) or sell (“put option”) at a specified price and time in the future.
The price that an option is purchased or sold for is known as the premium, while the price that the option can be used for is known as the exercise price. All options have expiration dates, whereby the option must either be exercised or expire worthless. Long-term options tend be more volatile than short-term options, while options with expiration dates more than a year into the future are known as long-term equity anticipation securities or LEAPS.
While stock options can be used to speculate on stocks, by purchasing the right to buy instead of the underlying stock for more leverage, they can also be used to hedge a portfolio against risk, by establishing a price floor or providing exposure to an offsetting asset. Long-term investors may want to focus on the latter benefits in order to reduce their portfolio risk and improve their overall risk-adjusted returns over time.
The most common options strategy that provides a hedge against risk is the protective put. By purchasing the right to sell stock at a set price, an international investor can guarantee that they will not lose more than a certain amount. The strategy may be particularly useful when risk situations arise where there’s a large potential for losses, such as a geopolitical crisis, run on a currency, or other situations where equities could take a hard hit.
For example, suppose that an international investor believes that Russia’s economy will recover and buys 1,000 shares of the Market Vectors Russia ETF (NYSE: RSX) at $14.16 a piece for a total of $14,160. The long position is risky given Russia’s dependence on oil prices and potential for geopolitical risk, which could send shares significantly lower if an adverse event happens over the next year, so the investor would like to buy a hedge.
By purchasing a 1-year put option with a strike price of $10.00, the investor could guarantee that they would not lose more than $4.16 per share. The put option costs $1.01 per contract, which means that full coverage of 1,000 shares would cost $1,010 or about 7% of the entire investment. If the stock rises, the investor loses the $1,010 entirely, but even if the stock falls to $5.00 per share, the investor will always be able to sell for $10.00 per share.
Most international investors are familiar with the idea of using ETFs to build exposure to global markets, but few investors take advantage of options on those ETFs. Using strategies like the protective put, investors can effectively buy insurance on their portfolios during risky situations that may arise from geopolitical or financial events. International investors shouldn’t ignore these unique tools, which can help them improve long-term financial performance.
In this article, we’ll take a look at how international investors can protect their portfolio using options on international ETFs.
Options 101
Stock options provide investors with the right or obligation to buy or sell shares of an underlying stock - including ETFs. When buying an option, the investor is purchasing the right to buy (“call option”) or sell (“put option”) shares at a specified price and time in the future. When selling an option, the investor is selling the rights to stock they are obligated to buy (“call option”) or sell (“put option”) at a specified price and time in the future.
The price that an option is purchased or sold for is known as the premium, while the price that the option can be used for is known as the exercise price. All options have expiration dates, whereby the option must either be exercised or expire worthless. Long-term options tend be more volatile than short-term options, while options with expiration dates more than a year into the future are known as long-term equity anticipation securities or LEAPS.
While stock options can be used to speculate on stocks, by purchasing the right to buy instead of the underlying stock for more leverage, they can also be used to hedge a portfolio against risk, by establishing a price floor or providing exposure to an offsetting asset. Long-term investors may want to focus on the latter benefits in order to reduce their portfolio risk and improve their overall risk-adjusted returns over time.
Protective Puts
The most common options strategy that provides a hedge against risk is the protective put. By purchasing the right to sell stock at a set price, an international investor can guarantee that they will not lose more than a certain amount. The strategy may be particularly useful when risk situations arise where there’s a large potential for losses, such as a geopolitical crisis, run on a currency, or other situations where equities could take a hard hit.
For example, suppose that an international investor believes that Russia’s economy will recover and buys 1,000 shares of the Market Vectors Russia ETF (NYSE: RSX) at $14.16 a piece for a total of $14,160. The long position is risky given Russia’s dependence on oil prices and potential for geopolitical risk, which could send shares significantly lower if an adverse event happens over the next year, so the investor would like to buy a hedge.
By purchasing a 1-year put option with a strike price of $10.00, the investor could guarantee that they would not lose more than $4.16 per share. The put option costs $1.01 per contract, which means that full coverage of 1,000 shares would cost $1,010 or about 7% of the entire investment. If the stock rises, the investor loses the $1,010 entirely, but even if the stock falls to $5.00 per share, the investor will always be able to sell for $10.00 per share.
Takeaway Points
Most international investors are familiar with the idea of using ETFs to build exposure to global markets, but few investors take advantage of options on those ETFs. Using strategies like the protective put, investors can effectively buy insurance on their portfolios during risky situations that may arise from geopolitical or financial events. International investors shouldn’t ignore these unique tools, which can help them improve long-term financial performance.