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Smart Investor: Efficient diversification using US sector etf options

Options 10 minutes to read
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Koen Hoorelbeke

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.


Introduction:

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

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.

Why choose US sector ETFs?

  1. Liquidity: US sector ETFs are highly liquid, ensuring ease of buying and selling. High liquidity means tighter bid-ask spreads and more efficient price discovery.
  2. Options availability: These ETFs have active options markets, allowing for strategies like purchasing long-term options (LEAPS). This availability makes them suitable for sophisticated strategies that go beyond simply holding the ETF.
  3. Comprehensive exposure: US sector ETFs cover a wide range of economic sectors, providing diversified exposure across different areas of the economy. This diversification helps reduce risk by spreading investments across various industries.
  4. Strength of the US economy: The US economy is one of the largest and most diverse in the world, leading many sectors such as technology, healthcare, and consumer goods. Investing in US sector ETFs allows investors to benefit from the resilience and innovation of the US market, which often sets trends and drives global economic growth.

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.

Choosing US sector ETFs

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:

  • Technology: SPDR S&P Technology ETF (XLK : arcx)
  • Healthcare: SPDR S&P Healthcare ETF (XLV : arcx)
  • Financials: SPDR S&P Financial ETF (XLF : arcx)
  • Consumer discretionary: SPDR S&P Consumer Discretionary ETF (XLY : arcx)
  • Consumer staples: SPDR S&P Consumer Staples ETF (XLP : arcx)
  • Energy: SPDR S&P Energy ETF (XLE : arcx)
  • Industrials: SPDR S&P Industrials ETF (XLI : arcx)
  • Materials: SPDR S&P Materials ETF (XLB : arcx)
  • Utilities: SPDR S&P Utilities ETF (XLU : arcx)
  • Real estate: SPDR S&P Real Estate ETF (XLRE : arcx)
  • Communication services: SPDR S&P Communication Services ETF (XLC : arcx)
  • Biotech: SPDR S&P Biotech ETF (XBI : arcx)
  • Emerging markets: iShares MSCI Emerging Markets ETF (EEM : arcx)
  • Small-cap stocks: iShares Russell 2000 ETF (IWM : arcx)
  • International developed markets: iShares MSCI EAFE ETF (EFA : arcx)
  • Gold miners: VanEck Vectors Gold Miners ETF (GDX : arcx)
  • Gold: SPDR Gold Shares (GLD : arcx)
  • Technology-heavy: Invesco QQQ Trust (QQQ : xnas)
  • US real estate: iShares U.S. Real Estate ETF (IYR : arcx)
  • S&P 500: SPDR S&P 500 ETF Trust (SPY : arcx)
  • Oil & gas exploration: SPDR S&P Oil & Gas Exploration & Production ETF (XOP : arcx)
  • Semiconductors: VanEck Vectors Semiconductor ETF (SMH : xnas)

Adding ETFs to your watchlist

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.

2024-06-20-00-watchlist-us-sectors-option-chain
  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.

 

2024-06-20-01-add-option-to-watchlist-us-sectors-options
Once your watchlist is populated with the chosen options, you can easily monitor their performance and start new trades as needed. The following screenshot demonstrates a watchlist with selected options for each ETF, from which you can initiate a new trade directly.
2024-06-20-02-trade-from-option-watchlist

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.

2024-06-20-03-IWM-long-call

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.

Check out these guides and case studies:
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. 
 


Options are complex, high-risk products and require knowledge, investment experience and, in many applications, high risk acceptance. We recommend that before you invest in options, you inform yourself well about the operation and risks. In Saxo Bank's Terms of Use you will find more information on this in the Important Information Options, Futures, Margin and Deficit Procedure. You can also consult the Essential Information Document of the option you want to invest in on Saxo Bank's website.

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