Thursday, January 29, 2009

Exploring Index/ETF Options

Just had a few thoughts I wanted to share regarding the benefits of trading options on an Index or Exchange Traded Fund versus stock.

1. Don’t have to worry about company events or news such as earnings, product releases, FDA announcements, etc…
Let’s say I’m playing an income type strategy on a stock like AAPL. Every quarter I’ve got to deal with an earnings announcement which serves as a catalyst to drastically increase the realized volatility of the stock (albeit it short term). That can be a pain in the neck when playing a strategy where I’m looking for stagnation, like say a calendar/iron condor. Playing an Index/ETF avoids all the drama and unknowns involved with earnings.

2. Typically have a lot more strike prices to choose from, which enables more flexibility in not only placing the trade, but adjusting as well.
If I’m placing a vertical spread on SPY I’ve usually got about 10 different strikes I could use to place a trade with risk-reward parameters I’m comfortable with. On the other hand, if I’m trying to place it on MSFT I’ve got maybe 2 to 3 strikes that have enough premium to make it worthwhile.

3. Depending on the index/etf, they typically exhibit less volatility than individual stocks within the index/etf.
When playing income type strategies, less volatility is serves as a benefit. For example, today the XLE (sector spdr energy ETF) was down 3.53%, but COP (ConocoPhillips) was down almost 6%.

4. The super liquid ETF’s (SPY, DIA, QQQQ, IWM.. etc.) have very tight bid/ask spreads.
To fully appreciate this advantage, try trading options on illiquid stocks for awhile. Ever traded an option with a $2.00 bid/ask spread? Kinda sucks being down $200 per contract right of the bat! Tighter bid/ask spreads should result in less slippage which can make the trade profitable a lot quicker.

This list is far from comprehensive, so feel free to add in other benefits you think I've left out. Furthermore, anyone want to play devil’s advocate by taking the other side of some of these assertions? Feel free to pipe in on the comments board. . .

Tyler -

2 comments:

Jim Brown said...

With regard to point number one, and having only been in the trading world for nine months now, I'm finding double calendars and iron condors my most comfortable areas to trade in right now. I love the protective nature of the risk graphs, like a desert tent in the case of an iron condor. And why not make it easier on myself by using a steadier ETF, or index fund. This type of trading does take some worry away, and I'm finding it a good place to start as the many other complexities of options trading sinks in. Thanks for starting the blog.

Tyler said...

Great points Jim. Glad you're getting more & more familiar with the IC's & Dbl Diag. trades.