How a buffer is built from options
Step through the four option positions behind a typical buffer and watch the payoff change at each step.
Visual guide
How a buffer is built from options
Simplified, hypothetical payoff at the end of one outcome period, with a 10% buffer and a 12% cap, before fees, expenses and option premiums. Not the terms of any fund.
How it works
Most buffer ETFs combine options on an index, usually FLEX options with a set expiration, to create the buffer and cap.
The four steps. 1. Own the index, which moves one-for-one with it. 2. Buy a put option at today's price, which removes losses but is expensive. 3. Sell a put option at a lower price, 10% down in the example, which pays for part of the first put; losses inside the first 10% are absorbed and losses beyond it return. 4. Sell a call option at the cap, which pays for the rest and gives up gains above the cap.
Worked example. The chart uses a 10% buffer and a 12% cap. Hypothetical, before fees, expenses and option premiums.
Assumptions. All options expire on the last day of the outcome period; real funds may use different strikes and structures.
FAQ
Frequently asked questions
What options does a buffer ETF use?
Typically a bought put near today's price, a sold put lower down that defines where the buffer ends, and a sold call that sets the cap, all expiring at the end of the outcome period.
What are FLEX options?
FLEX options are exchange-listed options with customizable strike prices and expiration dates, which lets a fund match its outcome period exactly.
Who pays for the buffer?
The investor does, by giving up gains above the cap. The premium from the sold call and sold put offsets the cost of the bought put.
Why does the cap change each period?
Option prices change with volatility and interest rates, so the cap that pays for a given buffer is set fresh at the start of each outcome period.
Learn more
- How Is a Buffer Built With Options? A Step-by-Step Look
- What Are FLEX Options, and Why Do Buffer ETFs Use Them?
- What Drives a Buffer ETF’s Cap?
- Buffer ETFs Explained
- All ETF calculators and tools
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For educational purposes only. This material is not investment, legal or tax advice, and it is not a recommendation or offer to buy or sell any security. Figures from third-party sources are believed to be reliable as of the dates shown but are not guaranteed. Investments involve risk, including possible loss of principal.