Thinking Outside the Stock: Trading Index and ETF Options

A beginners guide to trading index and ETF options

Oct 7, 2016 at 9:35 AM
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Typically, investors interested in options tend to focus on buying or selling calls and puts on particular stocks. However, options aren't just limited to equities. Index and exchange-traded fund (ETF) options allow traders to speculate on -- or hedge against -- the broader market or an entire sector.

For example, the S&P 500 Index (SPX) is an index based on 500 large companies, and is often considered the "broad-market barometer."  The Russell 2000 Index (RUT) is widely considered the benchmark for small-cap stocks. Traders looking to hedge their portfolios more broadly -- perhaps against an election-inspired sell-off -- could purchase puts on the indexes' ETF counterparts, the SPDR S&P 500 ETF (SPY) and iShares Russell 2000 Index Fund (IWM), respectively.

An ETF can also represent an even narrower group of stocks or a specific sector, and trades in roughly the same manner as a stock. Playing index or ETF options is similar to playing options on any other kind of equity, but they allow traders to reap benefits of sector-wide rallies or declines by widening their exposure to more than just a single equity.

For example, a recent analysis conducted by Schaeffer's Senior Quantitative Analyst Rocky White found "precious metals" to be one of the sectors with the best Expectational Analysis® set-ups (bullish price action vs. negative sentiment) right now. The 24 stocks under this umbrella average a year-to-date stock return of 117.4%, while the VanEck Vectors Gold Miners ETF (GDX) has racked up a 72% year-to-date return. Buying GDX calls would allow bullish speculators to profit from a broader precious metals rebound.

On the other hand, the biotech sector is near the bottom of our Sector Scorecard. The 53 stocks under this umbrella average a year-to-date loss of 6.8%, yet two-thirds of analysts uphold "buy" or better ratings. Buying puts on the iShares NASDAQ Biotechnology Index (ETF) (NASDAQ:IBB) -- which is down 19% in 2016 -- would allow bearish speculators to profit from a broader biotech decline. 

Likewise, if a trader is bearish on, say, Darden Restaurants, Inc. (NYSE:DRI) or recently battered Chipotle Mexican Grill, Inc. (NYSE:CMG), but has reason to believe restaurant stocks could reap the rewards of the holiday season, she could hedge her short stock position with long calls on an ETF such as The Restaurant ETF (NASDAQ:BITE). This protects the trader from the risk of betting on a single security. 

Investing in indexes and ETFs is by no means a surefire way to ensure profits. However, they do provide useful tools that can help traders widen their exposure to an entire sector or index, as well as hedge against risky equity-based option moves.

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