Smart Investor: Efficient diversification using US sector etf options

1. Navigate to the "Trading" section of your brokerage platform.
2. Access the "Watchlists" tab and create a new watchlist.
3. Name the new watchlist "Selector ETFs (US)".
4. Select "Sector ETFs (US)" from the dropdown menu to filter the relevant ETFs.
5. Add instruments by searching for the ticker symbols and including them in your watchlist.
6. Open the "Option Chain" for a specific ETF to view available options.
7. Select options with desired expiry dates and strikes, focusing on high-liquidity options for better execution.

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.

Practical Example: Comparing Buying the ETF vs. Buying a Long-Term Call Option

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.

Why choose a call with delta 0.80 and expiry January 2026?

• Delta 0.80: This is a conservative distance in the money, providing a buffer against negative moves. It allows the option to behave more like the underlying ETF, reducing the impact of small price fluctuations. Higher or lower deltas can be adjusted for personal preferences, depending on risk appetite.
• Expiry January 2026: Choosing an expiration date far enough away supports a long-term bullish view and minimizes the impact of theta decay. This longer timeframe allows more room for the underlying ETF to move in the desired direction.

Buying the ETF

Pros:

• Ownership: Direct ownership of the ETF shares, including any dividends paid out.
• No expiration: Can hold indefinitely, allowing for long-term capital appreciation.
• Less sensitivity to time decay: No theta decay as with options.

Cons:

• High capital requirement: Requires significant initial investment to buy shares outright.
• Full exposure to downside risk: The full amount invested is at risk if the ETF price drops.

Buying the Long-Term Call Option

Pros:

• Leverage: Control a larger number of shares with less capital. For example, buying a call option for 172 strike with a premium of $4,460 allows control of 100 shares.
• Limited downside risk: Maximum loss is limited to the premium paid ($4,460 in this case).
• Profit potential: Significant upside potential if the ETF price rises above the breakeven point (216.60).

Cons:

• Expiration: The option expires in January 2026, requiring accurate timing of price movements.
• Time decay: Value of the option erodes over time due to theta decay, especially as expiration approaches.
• No dividends: Option holders do not receive dividends from the underlying ETF.

Profit/Loss Comparison at Expiration

• ETF Purchase:

  • Initial investment: $20,027 for 100 shares at $200.27 per share.
  • Breakeven: $200.27 per share plus any dividends received.
  • Risk: Full amount of $20,027.

• Long-Term Call Option:

  • Initial investment: $4,460 for one call option with a 172 strike price.
  • Breakeven: $216.60 (strike price of $172 + premium of $44.60).
  • Risk: Maximum loss of $4,460.

Scenario Analysis at Expiration:

• If IWM rises to $250:

  • ETF:
    • Profit: $4,973 ([$250 - $200.27] x 100 shares).
    • Relative P/L: 24.85% ($4,973 profit / $20,027 investment).
  • Option:
    • Profit: $3,340 ([$250 - $172] x 100 shares - premium paid).
    • Relative P/L: 74.88% ($3,340 profit / $4,460 investment).
       

• If IWM drops to $150:

  • ETF:
    • Loss: $5,027 ([$200.27 - $150] x 100 shares).
    • Relative P/L: -25.10% ($5,027 loss / $20,027 investment).
  • Option:
    • Loss: $4,460 (premium paid, as the option expires worthless).
    • Relative P/L: -100% ($4,460 loss / $4,460 investment).

Risk/Reward Profile

Buying the ETF:

• Risk: High initial capital required, full exposure to price declines.
• Reward: Full participation in price increases, potential dividends, indefinite holding period.

Buying the Long-Term Call Option:

• Risk: Limited to the premium paid, risk of total loss if the ETF does not rise above the breakeven point by expiration.
• Reward: Leverage amplifies potential gains, lower initial capital outlay, limited downside risk.

Conclusion

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.