New ETF Sells Options For Income

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The new U.S. Equity High Volatility Put Write Index Fund (NYSEArca:HVPW) from ALPS is only the latest ETF that explicitly uses options in its strategy.

HVPW is perhaps the boldest and most explicit derivatives-based income play in an ETF wrapper to date.

The fund explicitly aims for a 1.5 percent distribution every 60 days. That's roughly 9 percent a year if things go well-a pretty enticing goal in today's next-to-nothing yield environment.

But for the average investors who's maybe not an expert in options-and I'd include myself in that camp-the fund's strategy is a lot to digest.

Naked puts. High volatility. Holdings that aren't intuitive. A new index.

Let's break down these elements one at a time.

Naked Puts

HVPW "writes" put options on each of 20 stocks, selling the right to buy stocks at roughly 85 percent of their price at the time. Investors who buy these "out of the money" options would exercise them if the stock's price falls below that strike price within the 60-day term of the option.

Hence the fund is on the hook for each of its 20 names for the difference in price below a roughly 15 percent drop. As these options are "American style," the investors who hold the options can exercise them if the stock price drops below the strike price any time during the 60 days.

In return for providing this insurance-putting a floor under the stock price by writing the option-the fund collects a premium.

The premium affects the breakeven math for each stock.

Let's say the stock costs $100 at the time the option is written, the strike price is $85 and the option costs $1. For this hypothetical stock, the fund would start to lose money if the stock price falls below $84 rather than $85.

The premium is of course the whole point-it's the engine that provides the stated goal of 1.5 percent distributions at the end of each 60-day period.

The puts sold by the fund are naked, meaning they're not hedged by offsetting positions. This means the fund's exposure to downside-below the breakeven point-is the same as if you owned the stock.

While that sounds reasonable, consider that the fund's maximum downside in the hypothetical stock above is -$84 while its upside is $1.

High Volatility

HVPW chooses options on stocks with the highest volatility.

A stock's volatility affects the premium of the option on the stock:Higher volatility means higher premium. This makes intuitive sense in that the strike price is more likely to be breached in the case of stock with a wildly swinging price compared with a sleepy name whose price rarely moves.

In this sense, HVPW's exposure to volatility is negative-it's selling volatility rather than having positive exposure to it.

High-volatility stocks will command higher premiums precisely because they're more likely to be exercised at a loss to the fund.

This risk and reward of the premiums is tempered significantly for strike prices that are 15 percent out of the money.

Holdings

The fund's holdings don't reflect its exposure intuitively. That's not a slight on the HVPW's issuer, ALPS, but simply the nature of the beast.

The 101.5 percent cash position is almost entirely collateral. This is an important point:The fund does not employ leverage as many options investors might expect.

For many, the whole point of using options is to get more exposure with less capital. For example, if you think that Google stock will shoot up soon, you can buy a share for, say, $832. Or you can use that same $832 to buy multiple call options to increase your upside potential.

HVPW doesn't use this kind of leverage. Its cash stake is roughly equal to the aggregate exposure of the strike prices of its options.

The economic exposure therefore isn't easily summed up in a holdings table.

The downside exposure is proportional to long positions in the underlying stocks at their breakeven points. The upside exposure equals the premiums received with some possible capital gains from stocks that moved below the strike.

New Index

New funds like HVPW don't have performance history, but often track existing indexes that do.

In this case, however, the fund's underlying index itself is also new, making performance comparisons impossible. The fund's fact sheet shows a one-year performance chart, but the data on Bloomberg and on the index issuer site starts about five weeks ago.

That's a shame. Options and other derivatives have nonlinear return patterns. And while put-writing strategies are hardly new, I'd want to see something like a five-year series based on this exact methodology, not a five-week pattern.

For conservative investors like me, the lack of a lengthy history is a deal-breaker, but we'll see if HVPW catches on.

Funds that produce income-or at least try to-have attracted lots of attention.

And at least one other options-strategy fund, PBP, has established itself with a long track record and assets of more than $235 million, according to our numbers.

In fact, I had hoped to compare HVPW's index with that of PBP since they should have similar return patterns-for reasons I won't go into here-but the lack of an index history for the ALPS fund prevents that.

At the time this article was written, the author held no positions in the securities mentioned. Contact Paul Britt at pbritt@indexuniverse.com.


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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs

Referenced Stocks: HVPW , PBP

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