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An exchange-traded fund (ETF) is a type of investment fund that holds a basket of assets and tracks an index, commodity, or basket of commodities. ETFs are traded on exchanges like stocks, and they can be bought and sold throughout the day. ETFs typically have lower fees than mutual funds, and they can be used to gain exposure to a wide variety of asset classes.
ETFs are a popular choice for investors who want to diversify their portfolios or access certain markets. For example, an ETF that tracks the S&P 500 Index can give investors exposure to large-cap U.S. stocks, while an ETF that tracks the price of gold can give investors exposure to the precious metal.
ETF options are derivative contracts that give the holder the right, but not the obligation, to buy or sell an ETF at a specified price on or before a certain date. ETF options can be used to hedge a portfolio or speculate on the future price of an ETF. However, unlike the index (SPX, NDX, RUT) options, ETF options have received less media attention and coverage.
Reference [1] examined the use of ETF options by hedge funds. It pointed out,
We analyze 15 years of portfolio disclosures of hedge fund managers to provide evidence that ETF option markets are used for informed trading about market volatility. Hedge funds’ demand for non-directional positions in ETF options strongly predicts greater volatility on the underlying ETF. The predictive power is particularly strong for simultaneous holdings of calls and puts (i.e., straddles), option positions on non-equity ETFs, and is not subsumed by forward-looking volatility expectations implied by option prices. Hedge funds’ positions in equity options predicts underlying stock volatility, too, but only the idiosyncratic (i.e., stock-specific) component of volatility. This highlights the unique character of ETF option positions in being informative about future systematic volatility.
In short, the article showed that
- Hedge funds actively use ETF options for speculating and trading purposes. These options include commodity, fixed-income, and real estate ETF options such as GLD, HYG, TLT, and IYR;
- Hedge funds’ ETF options strategies deliver alpha. They achieve this by having a superior volatility timing ability.
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References
[1] Aragon, George O. and Chen, Shuaiyu and Shi, Zhen, Volatility Timing Using ETF Options: Evidence from Hedge Funds (2022). https://ssrn.com/abstract=4246146
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