Quarterly Outlook
Macro Outlook: The US rate cut cycle has begun
Peter Garnry
Chief Investment Strategist
Investment and Options Strategist
Summary: This article explores sector diversification using long-term options on US sector ETFs. We cover the importance of US sector ETFs, how to add them to a watchlist, and compare buying the iShares Russell 2000 ETF directly versus purchasing a long-term call option. This strategy offers leveraged exposure with reduced capital and controlled risk, but requires careful due diligence and risk management.
Diversification is a cornerstone of investing, aimed at minimizing risk by spreading investments across a variety of assets. By diversifying, investors can reduce the impact of a poor-performing investment on their overall portfolio, ensuring more stable and predictable returns over the long term. Traditional diversification involves spreading investments across different asset classes such as stocks, bonds, and real estate. However, a more nuanced approach involves sector diversification, which can be effectively achieved using sector ETFs.
In this article, we'll explore how to implement sector diversification not by buying the ETFs directly, but by purchasing long-term options on these ETFs. This strategy allows investors to gain leveraged exposure to various sectors, requiring less capital upfront and providing greater flexibility. Long-term options, or LEAPS (Long-term Equity Anticipation Securities), can offer significant advantages such as limited downside risk and enhanced potential returns.
In the first part of this article, we'll look at US sector ETFs and how to add them and their options to a watchlist. In the second part, we'll examine a specific example of buying a long-term option on an ETF, comparing it to the actual purchase of the ETF itself.
Important note: the strategies and examples provided in this article are purely for educational purposes. They are intended to assist in shaping your thought process and should not be replicated or implemented without careful consideration. Every investor or trader must conduct their own due diligence and take into account their unique financial situation, risk tolerance, and investment objectives before making any decisions. Remember, investing in the stock market carries risk, and it's crucial to make informed decisions.
US sector ETFs are exchange-traded funds that focus on specific sectors of the economy, such as technology, healthcare, or energy. These ETFs allow investors to gain exposure to a broad range of companies within a particular sector without having to pick individual stocks. Sector ETFs are an excellent way to diversify a portfolio and target specific areas of growth or stability within the market.
In this article, we focus exclusively on US sector ETFs. Diversifying using US ETF options should be part of a larger diversification strategy that does not limit itself to US markets only. Since we're utilizing options, it is most opportune to use those markets that provide the most liquidity. However, this does not exclude the use of similar strategies with major Eurozone companies or other global markets where liquidity is sufficient.
When selecting US sector ETFs, it's important to consider the sectors you want exposure to and the specific ETFs that best represent those sectors. Here are some popular US sector ETFs and their tickers:
To manage these ETFs efficiently, you should create a watchlist on your Saxo platform. The following screenshot provides a detailed guide on how to do this. In this example we're using SaxoTraderGo (via saxotrader.com). A similar setup can be found on the other Saxo platforms.
By creating a watchlist, you can keep track of these ETFs and their options, making it easier to implement your diversification strategy with long-term options.
Next, we'll discuss a practical example of how to use long-term options to diversify an existing portfolio.
To illustrate the benefits and drawbacks of buying an ETF versus buying a long-term call option on the ETF, let's consider the iShares Russell 2000 ETF (IWM : arcx). This example is chosen purely at random and does not reflect a specific bullish or bearish view on this ETF. Investors should perform their own due diligence before making any investment decisions. Below is a detailed comparison using a simple long call option with a delta of 0.80 and an expiry date in January 2026, compared to directly acquiring the ETF itself.
Buying long-term call options on sector ETFs can provide a powerful and capital-efficient way to gain leveraged exposure to specific sectors of the economy. While this strategy comes with its own set of risks, including time decay and the need for accurate timing, it offers limited downside risk and significant upside potential. By comparing this approach to outright ETF purchases, investors can make informed decisions on how to diversify their portfolios effectively. This method allows for a balanced approach, leveraging the benefits of both direct ownership and options trading to achieve optimal results.
For instance, the long-term call option on IWM allows you to control the same number of shares with significantly less capital, reducing your downside risk to the premium paid while maintaining the potential for substantial gains if the ETF price increases. On the other hand, direct ownership of the ETF provides steady growth and dividends without the risk of expiration, but requires a higher initial investment and exposes you to full downside risk.
Check out these guides and case studies: |
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In-depth guide to using long-term options for strategic portfolio management Our specialized resource designed to learn you strategically manage profits and reduce reliance on single (or few) positions within your portfolio using long-term options. This guide is crafted to assist you in understanding and applying long-term options to diversify investments and secure gains while maintaining market exposure. |
Case study: using covered calls to enhance portfolio performance This case study delves into the covered call strategy, where an investor holds a stock and sells call options to generate premium income. The approach offers a balanced method for generating income and managing risk, with protection against minor declines and capped potential gains. |
Case study: using protective puts to manage risk This analysis examines the protective put strategy, where an investor owns a stock and buys put options to safeguard against significant declines. Despite the cost of the premium, this approach offers peace of mind and financial protection, making it ideal for risk-averse investors. |
Case study: using cash-secured puts to acquire stocks at a discount and generate income This review investigates the cash-secured put strategy, where an investor sells put options while holding enough cash to buy the stock if exercised. This method balances income generation with the potential to acquire stocks at a lower cost, appealing to cautious investors. |
Case study: using collars to balance risk and reward This study focuses on the collar strategy, where an investor owns a stock, buys protective puts, and sells call options to balance risk and reward. This cost-neutral approach, achieved by offsetting the cost of puts with the premiums from calls, provides a safety net and additional income, making it suitable for cautious investors. |
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