ETF gives you an easy way to trade options

By Jason Chow
Globe Investor Magazine Online, February 13, 2008

Investing in options is far too complicated for most of us. Typically, we accept ignorance, turn a blind eye and let the hardcore traders deal with them.

But there is now an elementary way for investors to get into the intimidating options market and the timing couldn't be better. Not only does the recently-launched exchange-traded fund called the PowerShares S&P 500 BuyWrite Portfolio (PBP-N) play options without forcing the investor to learn the nuances between "calls" and "puts," it also promises to be a decent shield against volatility. In other words, it could be exactly the kind of thing you'd want a bit of in your portfolio during these roller-coaster times.
The new ETF, which was launched two months ago, is still in its infant stages -its market capitalization is still less than $3-million (U.S.)-and it has barely made a blip among investment experts and even ETF blogs. However, the BuyWrite ETF is based on an intriguing concept that merits attention and it offers exposure to the options market in a way that few regular investors would ever do themselves.

HOW IT WORKS

The BuyWrite ETF is based on one of the most basic options strategy called, not surprisingly, buy-write. The investor buys stocks and "writes" (insider jargon for "sells") call options against the stock. A call option is a tradable contract that gives the owner the right to purchase a certain amount of stock at a set price at a certain time. Typically, the option is written so that the buyer can buy the stock at exactly the same price in a month's time. (Traders call this type of contract an at-the-money call option.)

Buy-write is essentially a classic hedging technique: The money from writing the options is an extra pad to protect declines in the portfolio holdings.

However, buy-write also limits the upside when the market is roaring: If the stock jumps in price over the next month, the holder of the option may force you in a month to sell your stock below market price and you'll have missed on the massive gains. And keep in mind that when the market really tanks, the buy-write strategy won't prevent a massive blood-letting. However, the profits from writing the options will mean the loss will be slightly less painful than if you had not used options at all.

BACK TO THE ETF

It is based on the Chicago Board Options Exchange S&P 500 BuyWrite Index which is a hypothetical portfolio of owning S&P 500 stocks and writing call options against the holdings. (Interestingly, the BuyWrite Index won the "Most Innovative Benchmark Index" award at the 2004 Super Bowl of Indexing Conference.)

PowerShares boasts that the BuyWrite Index is less volatile than the S&P 500 and offers slightly better returns. While historical returns never predict the future, the facts do prove them right: BuyWrite has an average annual return of 7.97 per cent over the past 10 years, better than the S&P 500's 6.57 per cent; and the BuyWrite index also has only 73 per cent of the S&P benchmark's volatility. Indeed, we options-naives were missing something all along: The options strategy provides a much smoother ride to better profits.

But the ETF, which has a management expense ratio of 0.75 per cent, gets even better: PBP also pays a dividend and the amount is based on two factors. First, the fund owns the underlying stocks of the S&P 500, so the ETF unit-holder will get the dividends from the stocks. Also, the ETF distributes cash to investors based on the extra dough it makes from selling options. This dividend changes monthly since the cash earned from the options will fluctuate.

There have been several securities based on the BuyWrite index - most have been closed-end funds that are more income-oriented- but this is the first time an ETF has mirrored this options technique. The advertising is certainly seductive: A steady dividend income with better-than-market returns and less volatility. Is it too good to be true? It just might be, which is why one expert is suggesting a wait-and-see approach.

"I would urge moderation," writes Roger Nussbaum, a portfolio manager at Arizona-based Your Source Financial, on thestreet.com. "PBP potentially offers a panacea with close-to-market returns and much lower volatility.... In the last few years I have maintained a position in one buy-write fund at a time at about a 3-per-cent weighting. This is the type of concept that people get too enamoured with and allocate too much money to, only to regret it when there is some kind of market dislocation."

Still, the idea behind PBP is intriguing enough to keep it on your watch-list. Track it over the next few months. If the ETF does come through on its promises, it's definitely worth including in your portfolio.

Special to the Globe and Mail