Exchange-traded funds, or ETFs, are essential tools for investors. They have grown in popularity in recent years and can be used to achieve a variety of investment goals. Think of them as a basket of securities you can buy or sell on the stock exchange through a brokerage firm. They’re suitable for all sorts of assets, whether you’re investing in traditional ones or alternatives such as currency or commodities.

While ETFs have always been useful tools, buffered ETFs, specifically, have become popular thanks to their ability to limit risk when investing. While the rewards typically aren’t as great when you use buffer ETFs, you’re protected against significant negative market changes. Learn what buffer ETFs are, and discover whether they’d be a good fit for your investment strategies.

What Are Buffer ETFs?

A buffer ETF is a type of ETF designed to offer flexible exchange options with certain limits and caps in place. Think of them as an agreement to sell at a certain price you set in advance that’s not entirely dependent on the stock’s value at a given time. After all, an ETF is more like an agreement about a given stock between the purchaser and writer rather than direct ownership of the stock.

These ETFs function using a combination of long and short puts, or an options contract that gives you the right to sell for a certain amount within a specific time frame. Keep in mind that put options give you the right, not the obligation, to sell. A buffer ETF works by having both a long put and a short put designed to mitigate risk.

A buffer ETF also has short and long call positions that essentially function as the opposite of put options. While put options give you the opportunity to sell at a certain price in a certain time frame, calls let you buy at a certain price in a certain time frame. You typically purchase puts when a stock price is expected to decrease and purchase calls when a stock price is expected to increase. Using a combination of both, buffer ETFs let you mitigate risk and enjoy benefits, albeit limited with a cap.

Key Takeaways

  • Buffer ETFs have a long, deep-in-the-money call position for the purpose of market exposure.
  • They have a long put to account for the potential risk.
  • They have a short call that’s out of the money.
  • They have a short put that is further out of the money than the long put.

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How Do You Get Returns With a Buffer ETF Strategy?

The returns you get with a buffer ETF are driven by the value of the underlying stock. The buffer ETF puts limits on the scale and direction of those returns, but they still depend on the stock itself. Put simply, if the returns are up on the stock, you’ll be able to enjoy those benefits, provided they don’t exceed the buffer ETF cap. If they do, your returns will flatline no matter how much the value of the underlying stock soars past the upside cap.

If the stock’s value drops, it works a bit differently. An inflection point will shield you from additional losses, but it doesn’t last forever. Should the value of the underlying stock fall beneath a second inflection point, further losses could affect the return on your investment.

What Are the Risks?

When using a buffer ETF strategy, you don’t face many risks if the underlying stock experiences moderate change one way or another. The risks instead lie in the potential for extreme changes. Should the stock’s price increase drastically, the central risk is opportunity cost. No matter how high the stock value climbs, you won’t benefit from it past the buffer ETF’s cap.

If the stock value drops past the second inflection point, the drop in value directly affects your capital. This is far more damaging than opportunity cost or missing out on potential benefits. Should the price fall too low, you could stand to lose significant capital. Remember, buffer ETFs are there to offer limited risk mitigation. You still stand to lose money should the underlying stock value decrease drastically.

Additionally, you must stay the course if you want to enjoy an ETF strategy’s benefits. Typically, you’ll need to buy in before it officially launches and hang onto it through its entire active period, which is typically about a year. If you buy in too late or opt out too early, you won’t get the structured returns that make ETF strategies beneficial in the first place.

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Why Do I Want Buffer ETFs in My Portfolio?

Adding buffer ETFs to your portfolio offers benefits you might not want to miss out on. Here are some of the most important.

Mitigated Risk

One of the key benefits of buffer ETFs is the mitigated risk they offer investors. While they don’t shield you from losses entirely, that first threshold can offer protections from modest losses in the market.

Varied Risk Profile

Given the relatively new and rising popularity of buffer ETFs, you’ll find a wide variety of options available when looking for the right fit for your portfolio. No matter what kind of ETF you’re looking for, there’s a good chance a brokerage has one. Just remember to do your research to find the right one.

Allows for Equity Diversification

You can easily diversify your equity through a variety of assets that all use buffer ETFs. No matter what kind of asset you want to invest in, the benefits are easily applicable. The returns, however, still depend on the changing value of that asset.

Forge the Path to Long-Term Wealth

With Infinity Investing, you can equip yourself with the skills necessary to take advantage of buffer ETFs and a wide variety of other tools in our financial arsenal. Sign up for a free membership today to enjoy the privileges of Infinity Investing. We have plenty of resources and events that appeal to market veterans and first-time investors alike.

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In this FREE event you’ll discover how the top 1% use little-known “compounders” to grow & protect their reserves. Our Infinity team of experts show you how to be the best possible steward of your finances and how to make your money and investments work for you instead of you working for them. Regardless of your financial situation today, you’ll have a road map to get to where you want to be.