Mat Cashman Mat Cashman, Principal of Investor Education at the OCC joins IBKRs Senior Trading Education Specialist Jeff Praissman to discuss buffered outcome ETFs.
For more free options education from The Options Industry Council (OIC), an industry resource provided by OCC, visit OptionsEducation.org.
Connect with OIC Instructor, Mat Cashman.
Summary – IBKR Podcasts Ep. 119
The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.
Hi everyone, welcome to IBKR podcasts. I’m your host Jeff Praissman. It’s my pleasure to welcome back to the IBKR podcast studio Matt Cashman, principal of investor education at the Options Clearing Corporation, or OCC.
Matt, welcome back. It’s always great to have you in the studio.
It’s a pleasure to be here, Jeff. Thanks for having me. I’m excited to talk about buffered ETFs.
It’s always great to have you. I’m excited for this subject. This is something that we have not discussed prior to that. So, for our listeners, buffered outcome ETFs, they’re also known as defined outcome or target outcome or even structured outcome. They’re sort of a recent innovation, correct?
Yeah, they’re pretty recent. I mean, I think they’ve been around for a little while, but we’ve really seen a lot of volume kind of migrate into these products as of late.
If you could go into why investors are using them and what role they play in a portfolio.
Yeah, absolutely. I think it’s good to start at the beginning here.
Generally, these products provide exposure for people that are looking to have exposure in really defined ways. So instead of someone who would naturally have a very long exposure to the marketplace and just be long all the time, sometimes what these will do for people is they’ll use a combination of underlyings and/or options and give people a real defined outcome as to when they want to belong in the market or where they want to belong in the market.
They’ll create strategies where you have kind of an out to the downside sometimes. And it really allows people to kind of target where and how they want to be long and make their capital really efficient as to how they view where they want their money at work basically.
So, generally just kind of gives them that limited upside exposure but kind of hedge between sort of a market sell off is general idea of these?
I would say the most common kind of expression of this for people is these limited upside exposure with a little bit of hedge to the downside. And so, what that means ultimately is that you have some sort of underlying exposure, but you’ve given up a part of the exposure that you want to the upside. You’re willing to give that up theoretically. But you want to be out of that long underlying position if, for instance, the market was to drop 10% or 15% or something along those lines. You’ll see a lot of different buffered ETFs that line up in that way. They give people that very defined outcome as to where and when they want to be actually long in the market.
Ah, so it’s really just how they’re structured and what they provide the investor, in other words. So, there’s a few different ways. It’s not one-size-fits-all, but it’s sort of a general idea, but then it can be structured slightly differently to provide different outsets.
Yeah, it’s different in different ways. And you’ll see these different products line up in different ways as to how they provide this exposure, right? There’s the exposure that I just explained, which is you’re giving up a little bit of the upside, but you get the downside. You get the downside out, basically. That takes you out of your position to the downside. There are also ways that people like to set these up where they utilize the yield that’s inherent in them to actually just give them unlimited upside exposure with a defined amount of premium that they’re willing to risk for that.
And then there are also ways that people create unlimited upside exposure, but also with that limited downside exposure. It’s important to note that when we’re talking about all of these things that most of these actual defined outcomes are created using options in the marketplace.
So it matters how your actual ETF that you’re purchasing actually utilizes those options. But any time that someone does a prospectus, or you read something in a prospectus that gives you the idea that there’s a defined outcome, inevitably, these people are actually using options to create those defined outcomes.
Besides our options, are other components that could make up a buffered ETF as well?
Yeah, absolutely. And this is really the heart of what we’re talking about here. And part of the reason why we wanted to talk about it today, I think, is to in some ways kind of demystify this whole asset class. Because it’s not rocket science as to what’s going on here. What we really have- it’s really two parts, two big parts.
The first part is some yield bearing instruments. So what people are doing is essentially dumping money into something that generates yield. Now with three-month, risk-free T-bills yielding 5.25 or 5.5% right now, that’s not a hard thing to find.
And if you were to tell me five years ago that I needed to get 5.25% to create this yield to then take that yield and trade options with it, I would tell you five years ago that’s impossible because it just doesn’t exist, right? There’s no risk-free actual rate back then that was that high.
However, now we’re in an interest rate environment that’s completely different. So, finding something that yields 5.25% is really not that hard, right?
So, you find a bond that yields some sort of duration, pays some sort of coupon and then what you essentially do is take the second part of this strategy. You take that yield, and you use it to trade the options. So, the options that are part of this trade or the options part of the ETF (this buffered ETF) are really being leveraged by the yield that’s created from this interest-bearing investment in some way shape or form.
And the options are what give these strategies their defined outcomes. The yield is really just used to pay for the optionality in some possible way or some iterative way that people have figured out how they want to structure that trade.
Got it, got it. So, you have the risk-free yield and then you have the option component. And are there option strategies that generally play better than others? I guess maybe that’s not the right way to phrase this. Are there options strategies that would generally be maybe more useful for this combination buffered ETF product than others?
Yeah, absolutely. I’ll frame it a slightly different way.
There are some options strategies that are far more common than others as far as the way that these are transmitted into the options market. The first one is really what I made reference to at the very beginning, which is if you are willing to essentially give up the upside exposure past a certain point, and you want some downside protection on your investment in the underlying, what that option strategy is generally called and has been used in the options market-making world for decades as far as just prudent risk management is concerned, people call that generally a risk reversal.
That’s what a risk reversal is in the actual options market-making world. What does that mean? It’s a long out-of-the-money put. So, a downside out-of-the-money put and you combine that with the short out-of-the-money-call. Now, most of the time when those two options are traded against each other (because you’re buying one and selling the other), the premium, generally speaking, can offset between those two, and so you don’t end up necessarily with a lot of premium outlaid for that strategy when you’re using a long downside put and a short upside call. That doesn’t cost a ton of money usually. Unless you’re doing something with a different strike to the downside that happens to cost more money when you’re outlaying the premium on the buy side.
So that’s one way to do it. Another way that people do it is a similar kind of vibe to that, but instead what they do is they use a put-spread collar or a put-spread risk reversal. Which means essentially, instead of just having one downside long put in that, you’re actually buying a put spread to the downside, which is buying the closest to the at-the-money put and then selling a farther down strike put against it. That’s the put spread part of it. And then you would utilize again that out-of-the-money call to the upside that you would sell against that to actually offset the premium and make it a relatively premium neutral strategy from just a premium perspective.
Got it. So then how does this buffered outcome strategy create returns for the investor then? So they’re putting the strategy on and they’re hoping for a certain move or maybe not move in market depending. But what are the scenarios where it could create the outcome?
Yeah, absolutely. Let’s talk about it this way.
Really the way that these products are designed is that they are designed to give you a return within a specific set of outcomes. So a lot of times if the returns on the market are up or down by a modest amount, then the buffered ETF is really expected to have a return that’s kind of in line with the underlying asset over that time period, right?
You’re not going to necessarily give up or get some turbocharged amount of return out of this. Because if you’re in that range of outcomes, the actual options themselves might not even come into play, right? You might even be within those strikes that were used to create that long optionality or short optionality. For instance, the long optionality to the downside with that long put we just talked about. And the short optionality to the upside.
If you didn’t end up touching either one of those strikes, the actual return on your investment might be very similar to what you might have had if you were just long the underlying. However, what you end up with in these and the reason why they’re called buffered ETFs, why they create a buffer or a defined outcome, is that if the market breaks through those upside or downside actual limits that you’ve created with the option trades on this, then that buffered ETF might either flatline to the downside, where you would get a capped loss to the downside. Again, that’s your defined outcome. Whereas if you were to compare that to someone who might be just straight long the underlying, you might, if you were straight along the underlying, have unlimited or relatively limited downside exposure all the way to 0 right?
It would be just like as if you were long the underlying stock. Or index in this case. And, so, what that might do is give you what I call an “out”. Or it might flat line your P&L which is what people are looking for.
And then on the upside, when you run into that short upside call theoretically as far if it were designed that way, you might get the actual exposure all the way up to where that call is struck, and then you wouldn’t be able to participate past that point. And sometimes the ETFs will design it as a percentage of the upside. You might not be able to participate past that point, but that would be where that short call might kick in and cap your actual exposure to the upset.
Any investment there’s always risk, right? So, from what you’re saying, it sounds like at least one of the risks of using this strategy would be extreme market moves. Where if it comes out of that that zone, are there any other risks or is that sort of the way the strategy works? Really it kind of protects you as long as it stays in the steady area but if there’s some sort of extreme movement, you’re not going to profit as much either. Or you may end up, you know, losing some on this.
Yeah. Well, I would say that the risks are fairly limited as far as this is concerned because what it’s designed to do is take risk off of the table. And in order to take risk off the table, you have to give up the availability of the upside in those in those cases we just talked about in order to get the downside coverage that you’re looking for. That’s how the options actually work, right? But what I’m talking about when you look at where this might be something people need to look out for is I always talk about the fees that are associated with it, right? Anytime someone says this is a buffered ETF or a defined outcome strategy, they’re probably using options.
And if they’re probably using options, what they’re doing is trading options in the marketplace, and they have to go into a marketplace, they have to cross bid as spread on the market trades that they’re making, or the option trades that they’re making.
So that’s going to be a potential slippage or fee that’s built into how these products work. The other thing that they have to do, and you have to think about this, is that options by design have an expiration date. Whereas the actual underlying that you might be buying or selling doesn’t necessarily have an expiration date. But what does that mean for this? It means that these options have to be rolled every time they get to a certain point where they might expire.
Because if you’re giving up the actual coverage that you’re getting with an option that’s expiring potentially in five days, the actual ETF is going to need to go in there and roll that option position out in time.
The reason they do this is to make sure that they have coverage so that their actual options market coverage meets the liabilities that they have if they have potential redemptions, right? If people come in and say “I don’t want to be a part of this ETF anymore, sell my ETF”, what you end up having to do is say, “Ok, they’re going to want their cash back.” You have to give them their cash back. What that means is that you don’t necessarily have as much cash to carry that options-position for as long.
So, they’re constantly doing this kind of dance where they match the duration of their option trades relative to the actual cash they have and relative to the cash flow that is being potentially created by these yield-bearing instruments.
And then looking at what their performance is benchmarked to some other indexes. Because if their performance is benchmarked and falls below benchmarks they consider they are going to get redemptions which lowers their cash et cetera. So, they’re constantly rolling their option strategies to make sure that their liabilities and their option strategies coverage are matched up and going out in time.
And then the third thing is that there are fees that are generally associated with these ETFs, and they will expressly tell you what their fees are. They’re usually fees that they express in basis points. Sometimes they can be as high as 100 or 200 basis points. It’s important that you understand where those fees are and how they’re charged. They’re usually very forthcoming with their fees in the prospectus. They’ll tell you what the basis point charges are on these things. The ETF provider is going to use those to cover their operational risks and cover other contingencies, et cetera, that they have from a business risk perspective.
So those are the three things that are really in there that might cost you money that are involved with this. They’re not necessarily risks that are built into being long the underlying, but they are potential fees that could be coming out of that investment.
Does the strategy work for single stocks? Or have these firms created this buffer strategy for single stock products? If not, is this something you see them potentially doing in the future?
You don’t see a lot of these in single stock trades. Where you see a lot of these right now are in indexes across the board, right? They will create a buffered strategy for a specific index where people will then be able to get exposure to that index and have coverage to the downside. Maybe give up a little bit to the upside, et cetera. You don’t see them a lot in single stocks right now.
I don’t necessarily think that it’s something that’s not out there on the horizon. I think that if people start to really request them from their broker or from their prime broker or hedge funds request them from the prime broker, they might start to show up because that’s always a function of the supply and demand that’s out there as far as products are concerned.
And I think personally that the actual single stock equity options market is a little bit more tailored to people doing this on their own. So you might see a lot of that flow of people doing it on their own in the single stocks relative to the indexes right now. And that’s part of the reason why people may have created these products in the indexes first. You never know. They might move into the single stocks and you might see that in five years or something like that. I don’t know, but it’s certainly a potential.
So that actually leads me to my last and final question. You know I just want to clarify for listeners, I know we’re talking about these ETF’s that are exchange traded and these firms are putting these together. But it sounds like this is something that investors could also do on their own for these ETFs through option trades as well. Is that an accurate statement?
I think it’s yes, it’s far more than accurate. It’s definitely 100% the way that I view these things. The bottom line here, when we’re talking about this, is that the ETF marketplace, as it stands right now, is very robust. And it’s the service that it provides and the actual way that it allows people to gain exposure to things that they wouldn’t otherwise have exposure to, It is really unparalleled, right?
And when you add on top of that the defined outcomes that people are starting to overlay on this, it’s incredibly robust as far as where you can and can’t go and buy risk that you want. It gives you an easily packaged up way to create risk where you want to have it and not where you don’t want to have it.
But, it comes at a cost. It’s not something that’s free. These ETF providers are charging you some amount of basis points. They’re telling you what they’re charging you. It’s a really transparent way that people are actually saying “Yes, we will give you this this amount of buffered risk, but it costs this amount of basis points”. And that’s good.
The thing that I think is really important from an educational perspective is that people understand that they can go create these things themselves.
Like I said at the beginning, it’s not rocket science, right? These people aren’t out there cooking up these things in laboratories and making them out of super complex mathematical formulas. What’s happening here is that they’re taking cash, they’re dumping it into a yield-bearing something, right, whatever that thing is. And then they’re taking the yield and they’re using the yield on the cash to actually buy or sell or a combination of buying and selling, sometimes options. And that’s all it is. And so, my point from a from an options-educator’s perspective, which is what I am, is that you can do this yourself. All you have to do is figure out “what is my duration risk?” What kind of option strategies am I willing to employ in order to create this buffered, defined outcome? And where do I want to actually have exposure? What are the underlyings in which I want to have exposure and where are the prices that I’m willing to be long it and where are the prices that I’m not willing to be long it?
Because that’ll give you a lot of color as to where you might want to put the strikes. For instance, that downside put that you might want to buy or the strike to the upside for that upside call where you might be willing to give up that further exposure to the upside. That might be where you strike the upside call.
But the point of the matter is, the more you understand about the actual underlying optionality, the more you understand about how those options work, the better equipped you’re going to be to be able to go create this strategy on your own.
And guess what? If you create it on your own, you don’t have to pay the 100 or 200 basis points. And that’s not to say that those people aren’t providing a great service. They are providing a great service and what they do is incredible. I’m just saying if you educate yourself as how the options work, you might be able to do the same thing for a little bit less money.
This has been great, and I actually learned a lot from this podcast. Again, the buffered ETFs are a fairly recent innovation, and they seem to be getting a little bit more popular too, like other investment related issues.
But this has been super educational and super helpful. Matt, I always appreciate you stopping by. And for our listeners, to see more educational material from the OCC, go to IBKR.com, click on ‘Education’ in the top right and ‘IBKR campus’. Then click on ‘Our contributors’ and look for the OCC. Thank you for listening and until next time, I’m Jeff Praissman with Interactive Brokers.
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Investors may lose their entire investment, regardless of when they purchase ETF shares, and even if they hold the shares for an entire Outcome Period. There is no guarantee that the Fund will be successful in its
attempt to provide the Outcomes for an Outcome Period. The Cap may increase or decrease and may vary significantly.
An investor who purchases Fund Shares after the Outcome Period has begun or sells Fund Shares prior to the end of the Outcome Period may experience results that are very different from the investment objective sought by the Fund for that Outcome Period. There is no guarantee that the Cap will remain the same after the end of the Outcome Period.
The Buffered Outcome ETFs’ investment strategies are different from more typical investment products, and the Funds may be unsuitable for some investors. It is important that investors understand the investment strategy before making an investment. For more information regarding whether an investment in the Fund is right for you, please see the prospectus.