BUFFER ETFS ARE SOMEWHAT COMPLEX, but if we peel back the ETF wrapper to look inside on the reset date, we can better understand how they work. And, by defining the role of each of the four option positions within the ETF wrapper, we can more easily understand how the downside buffer and upside cap are created (and the costs involved) at the beginning of the outcome period.
As you know, the “buffer” provides a protective layer designed to absorb a specific percentage of losses over a defined outcome period. Think of it as protection that shields an investor’s portfolio down to a certain level during the outcome period, which is typically 12 months. For example, the 15% buffer provided by Innovator’s U.S. Equity Power Buffer – November series (PNOV), is designed to protect an investor against the first 15% loss. If this buffer level is breached at the end of the outcome period, an investor would experience a loss on the position. This assumes a purchase at the start of trading on the reset date. Intra-outcome purchases will have different defined outcome parameters.
A Buffer ETF strategy is achieved by using four different FLEX options, which are uniquely versatile due to their customizable nature. They allow the ETF issuer to tailor protection and outcome parameters.
In the table you can see inside the ETF wrapper of PNOV at the start of trading on November 1, 2022, after its reset, and at the start of the new outcome period.
PNOV Reset Day – November 1, 2022
| Date | Ticker | Transaction | Security Name | Shares | Price | Market Value | Weighting | Layer | Notes |
| 11/1/22 | PNOV | Buy call | SPY 10/31/2023 3.86 C | 8283 | 375.79 | $311,266,857.00 | 98.06% | 1 | 1:1 S&P 500 ETF Upside |
| 11/1/22 | PNOV | Sell call | SPY 10/31/2023 465.46 C | -8283 | 10.53 | ($8,721,999.00) | -2.75% | 3 | 20.5% Upside Cap |
| 11/1/22 | PNOV | Sell put | SPY 10/31/2023 328.28 P | -8283 | 14.48 | ($11,993,784.00) | -3.78% | 2 | 15% Buffer |
| 11/1/22 | PNOV | Buy put | SPY 10/31/2023 386.21 P | 8283 | 31.56 | $26,141,148.00 | 8.24% | 2 | 15% Buffer |
| 11/1/22 | Cash & Other | 1.0 | $693,079.91 | 0.22% | Cash | ||||
| Net Assets | $317,411,797.50 |
Definitions
Ticker: Buffer ETF trading symbol
Transaction: Purchase or sale of option contracts
Security: Option contracts purchased or sold
Shares: Number of shares
Price: Cost of the security
Market Value: Dollar value of the purchase or sale of the option contract
Weighting: Percentage weighting of each security held in the ETF
Net Assets: Net dollar amount held in the ETF following the reset
Layer 1: Buy a call option to provide synthetic 1:1 exposure to the reference asset (SPY).
Layer 2: A) Buy a put option to provide downside protection on the reference asset. B) Sell a put option (to help fund the purchase of the protective put) with a strike price at the level where the protection will end (-15%).
Layer 3: Sell a call option (to help fund the purchase of the protective put). The premium received from the sale of this call option will determine the level of the cap during the outcome period. Any gain of the reference asset that surpasses the upside cap will be effectively forfeited by the investor. This is the cost of having a level of protection in place during the outcome period.
Understanding the role of each option layer:
Layer 1
On the reset date, a call option was purchased that provided synthetic 1:1 exposure to the reference asset (SPY) that PNOV is designed to track. 98.06% of the available cash in the ETF on the reset date was used to purchase this call option. It cost $311,266,857 to provide the exposure to the reference asset.
Layer 2
Layer 2 is a put spread – a purchase and a sale of a put option. Together the long and short put create the buffer, ensuring protection against initial losses. The purchase of the put provides downside protection for the approximately $311 million that was invested to track the reference asset. Note, for PNOV, the purchase of the put provided downside protection from the current price of SPY, $386.21 to $328.28, which is approximately 15% below the current price.
The cost of the protective put was $26,141,148. This dollar amount, plus the cost of the call option in Layer 1, means there is now a dollar deficit in the ETF. There’s not enough money to pay for both options purchased. So, the ETF must sell options (collect premiums) to offset the cost of the protective put.
The second option position in Layer 2 involves the sale of a put with a strike price at $328.28. This sale helps fund the cost of the protective put, but it also means that if the buffer limit is exhausted at the end of the outcome period, any further loss in SPY will see the ETF’s value decrease by the same percentage (1:1). The strike price is 15% below the current level of the reference asset ($386.21 – $328.28 = $57.93). 57.93/386.21 = 15%. The sale of the put option raised $11,993,784 in a premium that will be used to partially pay for the purchase of the put option.
Again, if the reference asset falls by 15%, the put spread will protect against the loss. However, because the ETF sold a put option with a strike price 15% below the current level of SPY on the reset date, it means the investor will no longer have protection if the 15% loss level is breached at the end of the outcome period (12 months later). The ETF shareholder will participate 1:1 in any loss greater than 15%. For example, if the reference asset falls 25% at the end of the outcome period, the ETF would lose 10% (25% – 15% protection = 10% loss, before fees).
Layer 3
The third and final layer of the options strategy is a sale of a call option on the reference asset. With this sale the ETF receives the call premium, and it also establishes an upside cap. The cap determines the maximum potential gain for the Buffer ETF during the outcome period.
The premium received from the sale of the call option will help fund the purchase of the protective put option in Layer 2. Again, the sale of the call option “caps” the return of the ETF during the outcome period. The call option in PNOV was sold at $465.46. This was approximately 20.5% above the price of the reference asset (SPY) on the reset date. If the reference asset gained more than 20.5% at the end of the outcome period, a PNOV shareholder would effectively forfeit the additional SPY gains. A shareholder’s maximum gain over the outcome period is capped at 20.5% (before fees), due to the sale of the call option. The option sale was necessary to help fund the cost of the protective put in Layer 2.
How are the new options purchased and sold on the reset date?
The four option contracts from the previous 12-month outcome period expire automatically. The assets in the ETF then roll into a new basket of options containing four contracts for the next outcome period. On the reset date (last business day of the month at the end of the outcome period), a package of the four option contracts is auctioned off to market makers. The options are not bought or sold separately, rather, they are packaged together. Once the highest bid is known, the cap level is determined for the upcoming outcome period. The upside cap level is the only unknown heading into each reset date. The buffer level remains the same as all prior outcome periods, and the reference asset is the same too, but the level of the upside cap will change. The cap level is typically influenced by both interest rates and volatility in the options market.
Note: A discerning reader may have noticed in the table of PNOV on its reset date, the premiums received from the sales of the put and call options did not fully cover the cost of the protective put. The protective put cost $26,141,148.00, but the sale of the put and call options only raised $20,715,783 ($8,721,999.00 + $11,993,784.00). So, there is a deficit of $5,425,365. How is there enough cash in the ETF to pay for the total cost of the protective put? Well, the purchase of the call option in Layer 1 was done at a “discounted” price that was basically ex-dividend on the reference asset (SPY). Buffer ETFs don’t pay dividends, so the call buyer effectively gets a discounted price on the options by the dollar amount of the dividends that will be paid during the outcome period. The annual dividend yield on SPY was approximately 1.7% on the reset date, which adds up to a little over $5 million, effectively covering the dollar deficit in the ETF.