ETF education ETF tax benefits: Why ETFs can be efficient investments
ETFs can be tax efficient because they rely on an in-kind creation and redemption process that helps limit capital gains distributions and investor taxes.
Options give investors the right to buy or sell a particular investment at a fixed price by a certain date.
Options may be able to effectively generate steady monthly income while maintaining exposure to stocks.
From flexibility to risk management, options offer a range of potential benefits for an investment portfolio.
When you think of investments to add to your portfolio, you probably think about stocks, bonds, commodities — even cryptocurrencies. Chances are that options don’t immediately come to mind. More investors are bringing options into their portfolios, however, because they can be useful tools for generating income and reducing downside risk, among other potential benefits. Access to professionally managed options-based strategies through exchange-traded products (ETPs) has never been easier. Here’s what options are and how they work.
Options are a type of financial instrument that gives an investor the right — but not the obligation — to buy or sell a set quantity or dollar value of a particular investment at a fixed price by a certain date. The name comes from the choice (or option) received in the agreement.
Option contracts are two main types: call and put.
The buyer of a call option believes the price of the underlying asset will increase in the future. If the asset price rises above the strike price during the specified term, the buyer can exercise the option. In other words, the investor can buy the asset at the lower strike price and sell it at the higher market price for a profit.
The buyer of a put option believes the price of the underlying asset will decrease in the future. If the asset price falls below the strike price before the option expires, the buyer can exercise the option. In simple terms, the investor can buy the asset at the lower market price and sell it at the higher strike price for a profit.
When an investor sells an option, they give the buyer the ability to buy or sell a specific asset by a certain date at a predetermined price. In return, the seller collects an option premium from the buyer. That’s considered income. Option income strategies can effectively generate steady monthly income while maintaining exposure to stocks.
Option income has a different set of sensitivities and drivers than income from dividend-paying stocks or traditional bonds. For example, a primary risk of traditional bonds is interest rate risk, which the Federal Reserve (Fed) has increasingly influenced. Stock options avoid interest rate risk and can deliver high income regardless of interest rates or the Fed’s actions. Instead, option income is impacted by stock market volatility and strike prices. High stock market volatility leads to higher option premiums (and vice versa).
Options can serve a broader purpose in a portfolio. Here are five other potential benefits.
Options are far from risk-free, especially for an inexperienced investor. Here are five inherent risks.
Investors who understand options and want to include them in their portfolios can get exposure to them in a variety of ways.
Call option: A financial contract that gives the holder the right — but not the obligation — to buy a specified amount of an underlying asset (usually in groups of 100) at a predetermined price within a set time period.
Expiration date: The date when an options contract becomes void and the right to exercise it no longer exists, ending the contract.
In the money (ITM): An options contract with intrinsic value, meaning a call option’s strike price is below the current market price of the underlying asset, or a put option’s strike price is above the current market price.
Option premium: The price that the buyer of an options contract pays to the seller for the rights conveyed by the option.
Out of the money (OTM): An options contract without intrinsic value, meaning a call option’s strike price is above the current market price of the underlying asset, or a put option’s strike price is below the current market price.
Put option: A financial contract that gives the holder the right — but not the obligation — to sell a specified amount of an underlying asset at a predetermined price within a set time period.
Spread: A trading strategy that involves simultaneously buying and selling two or more options contracts on the same underlying asset with different strike prices, expiration dates, or both to limit risk and potentially enhance returns.
Strike price: The predetermined price at which the options contract holder can buy (a call option) or sell (a put option) the underlying asset.
Underlying asset: The financial instrument, such as a stock, bond, commodity, or index, upon which the value of an options contract is based and which the option holder has the right to buy or sell.
ETFs can be tax efficient because they rely on an in-kind creation and redemption process that helps limit capital gains distributions and investor taxes.
The fair market of an ETF may be gauged by its net asset value (NAV), which is based on its underlying assets, leading to premiums and discounts.
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Image: Credit: J. Anthony / Stocksy
All investing involves risk, including the risk of loss.
Past performance does not guarantee future results.
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.
In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.
Financial leverage refers to the use of debt to acquire additional assets.
A decision as to whether, when and how to use options involves the exercise of skill and judgment, and even a well-conceived option transaction may be unsuccessful because of market behavior or unexpected events. The prices of options can be highly volatile, and the use of options can lower total returns.
This material must be preceded or accompanied by the Characteristics & Risks of Standardized Options Document. To obtain a copy, go to: OCC - Options Disclosure Document (theocc.com).
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