In many of my trades and examples, I've chosen to trade ETF options rather than stock or index options. I have three basic reasons why I prefer them. I'll get into that in a little bit.
Before I do, I want to provide some basic background on ETFs, what they are and how they compare to stocks. ETFs, short for Exchange Traded Funds can be thought of as a kind of mutual fund that is traded on a regular stock exchange - just like a stock.
On the outside, they seem pretty straightforward but behind the scenes, there is a little bit of complexity that goes into creating and managing an ETF. Like mutual funds, ETFs may represent a bundle of stocks in a given index, sector or asset class. They are often subject to a small management fee similar to mutual funds but usually much smaller. Unlike mutual funds, ETFs trade like a stock.
That means any brokerage where you can trade stocks, you can also trade ETFs. Also, unlike mutual funds, you are not subject to hidden capital gains taxes. Capital gains are calculated based on when you bought the ETF and when you sold it Here's the nice part Like stocks, many ETFs have options.
That means I can trade options on the broad market much like trading index options. ETF options usually trade like stock options, which means they are 'American style' options that can be assigned at any time, stop trading the third Friday of the month and expire at noon the next day.
So, enough chit chat about the ETFs themselves. As promised, here are some reasons why I like to trade ETF options. As I mention on my index option page , I have become more of a fan of trading the broad market. While there may be stronger up and down moves on individual stocks, there are less surprises with the indices and ETFs. On the index option page, I've also mentioned some of the disadvantages of trading index options, which naturally makes ETF options a great alternative.
With ETFs I practically have the ability to trade anything as if it were a stock. Just to bring it down to earth, let me give some examples. Let's say I wanted to trade something really broad and diverse. Another good broad index is the Russell - that's small cap stocks in this index. What about a sector? Let's say I want to trade the financial sector.
XLF represents stocks in the financial sector. That would be the XHB. How about emerging markets? Or, what about a specific emerging country? EEM represents a basket of stocks for all emerging markets. There are new ETFs being created practically every day.
It isn't difficult to find one to represent an asset class I'm interested trading. The trick is finding one that meets my criteria for trading options on it. More on this later. Many, but not all ETFs trade in high volumes. This is particularly true of the ETFs that represent broad market indices. More and more institutions, as well as retail traders are becoming interested in trading them. As a result, many ETFs trade at volumes equal to and greater that some of the most popular stocks.
Given that the ETF itself trades high volumes, the options are often traded in large volumes as well. This can be determined by looking at the open interest for any given strike in a given month. What I mean by good fills is that when I set an order price right between the bid and the ask, I often get filled fairly quickly. When large numbers of options are traded at any given time, market makers are often motivated to take my offer simply to get my order out of the way so they can take larger orders - a good reason to make sure my order size is a very small percentage of the open interest.
I didn't notice this as much when I was trading stock options more regularly. One was too high of a probability and the next one was too low. It's pretty easy to find just the one I want. One risk is the the same as trading any mutual fund, index or even a stock. The market can turn and I can loose money.
The nice thing about ETFs is that, just like a stock, I can set stops and limits and be out immediately. The same goes for options on the ETF. The main risk I think about when considering ETFs is that I don't know the exact mechanics of that ETF in terms of how it is valued and how it behaves relative to the basket of assets it represents.
This can affect the results of an option trade based on that particular ETF. The combination of leverage on the ETF plus leverage on the options can drain your trading account.
The main way to overcome or manage these risks is to be well educated on the ETF you are trading. Every ETF has a prospectus, much like a mutual fund so it's pretty easy to research the ETF to determine if it is one worth trading. Additionally, it is a good idea to spend some time following the ETF and perhaps paper trading with it before going 'live'. I have my favorite ETFs that I like to trade and I use them over and over again, regardless of the direction they are moving.
If you are just starting out, you may be wondering where to find ETFs that make good option trading candidates. Here are some basic steps to take. Finally, here are a list of good websites that can be used to research ETFs. Remember to make sure you not only know what index, sector or asset class it represents but how it behaves. Back to Option Trading Strategies.
Back to Success With Options home. Check out these full length videos that contain lots of specific information about trading spread strategies at an excellent value.
I set up and discuss the trades and then follow them up with periodic reviews until they close. For more detail go to the Options Trading Videos page. What is an ETF? Newsletter Subscription Name Email I keep this private Subscribe now to receive your free promotional package. Video Store Check out these full length videos that contain lots of specific information about trading spread strategies at an excellent value. Name Email I keep this private Subscribe now to receive your free promotional package.More...