How to choose your ETF fund

Exchange-traded funds (ETFs) are closed-end investments purchased on an Exchange. They are passively managed funds which mirror the performance of specific indices by tracking the performance of the individual stocks that comprise each index. The major advantages of ETFs are (1) low cost structure, (2) tax efficiency and (3) ability to be traded throughout the day. Yet, an even greater advantage is the ability to buy and sell options on many ETFs, which offers investors the flexibility to execute more sophisticated trading strategies that transcend simple ownership of the ETFs.  

Investors, who expect a market rally in an underlying index, buy call options on a corresponding ETF, and acquire the right to buy shares of the ETF at a specific strike price. Call holders are not forced to exercise the options, but if they do, the call writers are obligated to sell shares at the strike price. If the option is not exercised due to the index moving in the opposite direction than the buyer’s expectations, the call holder loses only the premium paid to enter the contract, while the call writer of the option contract gains the premium either way.  

Example

We assume that today an investor instructs a broker to buy on December a call option contract on Coca Cola Co. (KO) with a strike price of $51.70. The broker relays these instructions to a trader at the Chicago Board Options Exchange (CBOE). This trader then finds another trader, who wants to sell on December a call contract on Coca Cola Co. (KO) with a strike price of $51.70, and the strike price for an option to buy one share is assumed to be agreed at $5.20. One stock option contract is a contract to buy or sell 100 shares, according to the law in the United States. Therefore, the investor must arrange for $520 to be remitted to the exchange through the broker. The exchange then arranges for this amount to be passed on to the party on the other side of the transaction. 

In above example the investor has obtained at a cost of $520 the right to bur 100 Coca Cola Co. (KO) shares for $51.70 each. The party on the other side of the transaction has received $520 and has agreed to sell 100 Coca Cola Co. (KO) shares for $51.70 per share if the investor chooses to exercise the option. If the price of Coca Cola Co. (KO) does not rise above $51.70 before December, the option is not exercised and the investor loses $520. Instead, if the Coca Cola Co. (KO) share price rises to $80 and the option is exercised, the investor buys 100 shares at $51.70 per share when they actually worth $80 per share, thus realizing a gain of $2,830 ($8,000 – 5,170). 

By and large, ETFs are profitable if an investor has a long-term horizon because the more the ETF is held, the lower are the costs incurred for the investors since it is not traded on a constant basis. In general, when buying ETFs, investors should set a clear investment horizon and be aware of the cost involved.