ETF Options. Presented by The Options Industry Council OPTIONS

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Gilbert Dalton
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1 ETF Options Presented by The Options Industry Council OPTIONS

2 ETF Options Options involve risks and are not suitable for everyone. Prior to buying or selling options, an investor must receive a copy of Characteristics and Risks of Standardized Options. Copies may be obtained by contacting your broker or The Options Industry Council at One North Wacker Drive, Chicago, IL In order to simplify the computations, commissions, fees, margin interest and taxes have not been included in the examples used in these materials. These costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any transactions. Investors should consult their tax advisor about any potential tax consequences. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. Past performance is not a guarantee of future results.

In order to simplify the computations, commissions, fees, margin interest and taxes have not been included in the examples used in these materials.

3 Presentation Outline Essential concepts ETFs what are they? Advantages of ETFs ETF option contract terms and features ETF calls and puts Strategies Buying calls Buying puts Covered calls Cash-secured puts

4 ETFs - Exchange Traded Funds Represent shares of ownership in a fund or investment trust Composition: basket of underlying index s component stocks Designed to correspond to both performance and yield of underlying index May offer dividend opportunities HOLDRS - Holding Company Depositary Receipts Direct ownership of component stocks voting/dividend rights Easily redeemable into underlying shares

performance and yield of underlying index May offer dividend opportunities HOLDRS - Holding Company

5 Advantages of ETFs Trade like a stock Exchange-traded Liquidity secondary market Similar commissions May be margined May be sold short even on downtick Easy to track Diversity with one trade Transparency stocks held are known

margined May be sold short even on downtick Easy to

6 Advantages of ETFs Passively managed No shareholder purchases or redemptions Lower expenses and management fees passed to investors Trade close to net asset value At slight discount or premium Unlike closed-end funds Tax efficiency Low portfolio turnover Generate fewer capital gains

Trade close to net asset value At slight discount or premium Unlike

7 ETF Options - Much Like Equity Options Standardized contract terms American-style Early exercise and assignment possible Physical settlement Underlying ETF shares change hands Pricing Factors Underlying price Volatility Time to expiration Interest rates Dividends

Physical settlement Underlying ETF shares change hands Pricing

8 ETF Options - Much Like Equity Options In-, at- and out-of-the-money Same relationship between strike and underlying Premium Quoted price x $100 Intrinsic value and time value Time decay Effects of decay and volatility on time value Greeks LEAPS may be available

Premium Quoted price x $100 Intrinsic value and time value Time

9 Why ETF Options? Why bother? Wide variety of strategies are available ETF options give you options!

10 ETF Options Are Tools ETF options provide investors with additional tools to execute their investment strategies ETF options make it possible to target investment objectives Reduce risk of holding ETFs Generate income from ETF positions ETF options have unique tradeoffs Know your risk vs. reward Potential to profit on personal forecast of broad market or industry sector performance

of holding ETFs Generate income from ETF positions ETF options have unique tradeoffs Know your

11 ETF Calls and Puts Important Terminology and Mechanics

12 What Are ETF Options? Contracts giving the buyer (holder) The right to buy or sell Contracts giving the seller (writer), if assigned The obligation to buy or sell 100 underlying ETF shares At the strike price At any time before expiration

13 Long ETF Calls Buyer (holder) has the right to buy 100 underlying ETF shares At the strike price per share At any time until the option expires Buyer pays premium (non-refundable) Net price paid per ETF share if exercised call strike price + call premium paid

until the option expires Buyer pays premium (non-refundable) Net

14 Short ETF Calls Writer (seller) has the obligation to sell 100 underlying ETF shares, if assigned At the strike price per share At any time until the option expires Writer receives premium (keeps whether assigned or not) Net price received per ETF share if assigned call strike price + call premium received

option expires Writer receives premium (keeps whether assigned or not) Net

15 Long ETF Puts Buyer (holder) has the right to sell 100 underlying ETF shares At the strike price per share At any time until the option expires Buyer pays premium (non-refundable) Net price received per ETF share if exercised put strike price put premium paid

16 Short ETF Puts Writer (seller) has the obligation to buy 100 underlying ETF shares, if assigned At the strike price per share At any time until the option expires Writer receives premium (keeps whether assigned or not) Net price paid per ETF share if assigned put strike price put premium received

the option expires Writer receives premium (keeps whether assigned or not)

17 Long or Short ETF Options Investor s Choices Long Option Short Option Exercise Accept assignment Let it expire Let it expire Sell to close Buy to close (cover)

18 ETF Options Strategies Buying Calls Buying Puts Covered Calls Cash-Secured Puts Fictional ETF = XYZ

19 Buy ETF Call Bullish position on underlying ETF Small cash outlay (compared to ETF purchase) Profit and loss potential Profit unlimited with increasing ETF price Loss pre-defined limited to premium paid

20 Buy ETF Call Example Opinion: bullish forecast on XYZ over next three months Motivation Speculate on rising XYZ price, or Purchase of XYZ shares Action XYZ currently trading at $150 Buy one 3-month XYZ 150 call Pay quoted price of $6.00 ($600 total)

Purchase of XYZ shares Action XYZ currently trading at $150

21 Example: Buy 1 XYZ 150 Call at $6 At Expiration ETF Price Value of Call Cost of Call Total Profit (Loss) (6) (6) (6)

22 Example: Buy 1 XYZ 150 Call at $6 Profit Unlimited Profit Potential Limited Loss = $ Increasing ETF Price Loss

23 Example: Buy 1 XYZ 150 Call at $6 If call exercised net XYZ purchase price: 150 strike + $6 premium paid = $156 per share

24 Buy ETF Put Bearish position on underlying ETF Small cash outlay (compared to short sale of ETF shares) Profit and loss potential Profit potential is substantial (limited only by ETF price declining to no less than zero) Loss pre-defined limited to premium paid

25 Buy ETF Put Example Opinion: bearish forecast on XYZ over next six months Motivation Speculate on declining XYZ price, or Insurance for XYZ shares held Action XYZ currently trading at $132 Buy one 6-month XYZ 135 put Pay quoted price of $7.00 ($700 total)

26 Example: Buy 1 XYZ 135 Put at $7 At Expiration ETF Price Value of Put Cost of Put Total Profit (Loss) (7) (7) (7)

27 Example: Buy 1 XYZ 135 Put at $7 Profit Substantial Profit XYZ at 0 Limited Loss = $ Increasing ETF Price Loss

28 Example: Buy 1 XYZ 135 Put at $7 If put exercised net XYZ sale price: 135 strike $7 premium paid = $128 per share

29 Covered ETF Call Moderately bullish position on underlying ETF position Premium received from sale of call (and kept) Profit and loss potential Profit potential limited Loss potential substantial with declining ETF price

30 Covered ETF Call Example Opinion: moderately bullish forecast on XYZ over next three months Motivation Limited downside protection for XYZ shares held Generation of income from sale of call Action 100 XYZ shares previously purchased at $52 XYZ currently trading at $54 Sell one 3-month XYZ 55 call Received quoted price of $3.00 ($300 total)

31 Example: Sell 1 XYZ 55 Call at $3 Buy 100 XYZ at $52 At Expiration ETF Price Long ETF Profit (Loss) Short Call Profit (Loss) Total Profit (Loss) 45 (7) 3 (4) 50 (2) (2) (7) 6

32 Example: Sell 1 XYZ 55 Call at $3 Buy 100 XYZ at $52 Profit Max Profit = $ Increasing ETF Price Loss Covered Call Long ETF

33 Example: Sell 1 XYZ 55 Call at $3 Buy 100 XYZ at $52 If call assigned, maximum profit: $3 XYZ profit + $3 short call = $6 ($600 total) Return on investment (over 3 months): If 100 XYZ paid for in full ($5,200) = 11.5% If 100 XYZ purchased on margin (50%) = 23% Downside protection on XYZ shares = $52 - $3 = $49 Below $49 the risk is the same as unhedged ETF shares Consider writing covered ETF calls tax-free in your Roth IRA

34 Cash-Secured ETF Put Neutral to slightly bullish Premium received from sale of put (and kept) Profit and loss potential Profit potential limited to premium received from sale of put Loss potential substantial with declining ETF price

35 Cash-Secured ETF Put Example Opinion: neutral to slightly bullish forecast on XYZ over next several months Motivation Speculative profit on sale of put, or Purchase XYZ shares at lower than current level Action XYZ currently trading at $52 Sell one 3-month XYZ 50 put for $4.00 ($400 total) Deposit $5,000 in brokerage account for total share purchase if assigned

36 Example: Sell 1 XYZ 50 Put at $4 Deposit $5,000 At Expiration ETF Price Value of Put Put Premium Received Total Profit (Loss) 40 (10) 4 (6) 45 (5) 4 (1)

37 Example: Sell 1 XYZ 50 Put at $4 Deposit $5,000 Profit Max Profit = $ Increasing ETF Price Loss

38 Example: Sell 1 XYZ 50 Put at $4 Deposit $5,000 If put assigned net XYZ purchase price: 50 strike $4 premium received = $46 per share

39 Summary Among the benefits ETF shares offer Diversity of market coverage with one trade Trade like stock on an exchange Lower management costs and certain tax advantages vs. closed-end funds ETF options are much like regular equity options Similar characteristics and contract terms Offer flexibility and a wide range of strategies Can be used for speculation Can be used to help control market risk Can be used to help generate income

40 Thank you for attending! OPTIONS

Buying Equity Call Options

Buying Equity Call Options Presented by The Options Industry Council 1-888-OPTIONS Equity Call Options Options involve risks and are not suitable for everyone. Prior to buying or selling options, an investor