Options Coach: How to Trade Index and ETF Options

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When investors first enter the realm of options trading, they typically stick to buying vanilla puts and calls on individual stocks. However, stocks aren't the only optionable entities on Wall Street. Whether you're bullish on utilities or bearish on regional banks, there's a good chance that you can find an index or exchange-traded fund ( ETF ) that aligns with your trading ideas. What's more, these vehicles allow you to diversify your portfolio, without loading up on a multitude of stocks or options, creating a low cost way to reduce risk.

But, before we get ahead of ourselves, let's back up a bit. An index is a statistical compilation of several stocks that are related in some manner into one number. For example, the S&P 500 Index ( SPX ) includes a broad swath of U.S. equities, but a stock must maintain a specific market capitalization and liquidity to garner inclusion, among other deciding factors.

why not trade ETF options? Meanwhile, an exchange-traded fund (more commonly referred to as an ETF) is an investment vehicle that contains a pool of securities representing a sector or specific index. ETFs are composed like mutual funds, but they trade just like stocks.

In other words, both indexes and ETFs represent the performance of a particular group or sector of the stock market. Whether you're interested in commodities, home builders, defense stocks, or alternative energy, I guarantee you can find an index or ETF that's focused on that specific sector.

So, how do you play ETF or index options? Just as you would any other option. Let's say that you anticipate a short-term rally in the airline sector. You could always buy stock in Delta Air Lines ( DAL ) and hope for the best -- but what if Delta's entire fleet is spirited away by pirates in the dead of night, and the shares tank as a result? You'd miss out on the entire airline-sector rally!

providing a buffer This is where index and ETF options come in handy -- if you're bullish (or bearish) on a given sector, but you want to protect yourself against weakness (or strength) in any one particular security within that group. In this instance, you could purchase a call option on the AMEX Airline Index ( XAL ).

By placing your bet on XAL, you'll gain exposure to sector heavyweights such as Delta, UAL Corp. ( UAUA ), Continental Airlines ( CAL ), and US Airways ( LCC ). If the group rallies as you expect, the use of a call option will maximize your profits. Ideally, the group's overall performance will effectively offset any outliers -- in the above worst-case scenario, that would be the hypothetically tanking shares of Delta. And even if the sector fails to soar, your only loss on the position will be the premium you paid to enter the option trade.

way to hedge You can also use ETF and index options to inexpensively hedge your stock holdings, your other option positions, or even your entire portfolio. For example, let's say you've decided to short a specific stock within the natural gas sector. However, you're concerned that rising natural gas prices could throw a wrench in your trading strategy. In order to hedge against this possibility, you could purchase a call option on the United States Natural Gas Fund ( UNG ). In this manner, you can take part in a sector-wide rally, and any gains in the long option will help to offset potential losses on the stock you sold short. Think of the premium you pay for the UNG call as a car insurance payment -- you hope you won't need it, but it's there just in case.

Alternatively, let's say that you anticipate a period of short-term weakness in the broader equities market. In order to buffer some of the losses in your stock portfolio, you could purchase put options on the S&P Depository Receipts ( SPY ). This ETF tracks the performance of the broader market as represented by the S&P 500 Index, so a SPY put option would allow you to capitalize on weakness in the market as a whole.

Overall, there's no reason not to trade ETF and index options. There are a variety of uses -- in addition to straightforward speculation, you can use them to hedge, or in tandem with other option plays as part of a pairs trade. There's no time like the present to familiarize yourself with these endlessly useful trading tools.

Schaeffer's Investment Research Inc. offers real-time option trading services, as well as daily, weekly and monthly newsletters. Please click here to sign up for free newsletters. The SchaeffersResearch.com Web site provides financial news, education and commentary, plus stock screeners, filters and many other tools. Founder Bernie Schaeffer is the author of the groundbreaking book, The Option Advisor: Wealth-Building Techniques Using Equity & Index Options .



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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This article appears in: Investing , Options


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