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10 Reasons to Use ETFs When Trading Options

10 Reasons to Use ETFs When Trading Options
How do investors and traders cope with a market that has fallen more than 40% in just one year and survive until greener pastures return?

Many traders have lived to tell the tale by trading both the long and short sides, or by taking a longer-term inverse (contra) Exchange-Traded Funds (ETFs) as a portfolio hedge. And it's the contras that have insulated them against the big slides.

These are funds that benefit from market declines and advances in price -- some approximately point-for-point and others by a factor of two. And they enable you to have all the benefits of shorting the market without the hassles of borrowing stock and incurring margin debt.

Here are 10 reasons why you should consider using ETFs when trading options:

• The Appeal Of Segments - Market segments -- financials, housing, oil and so on -- have been hit hard, but often an individual name trades against the segment. If you think oil is moving in a certain direction, do you really want to pick one or two winners or losers or is it smarter to play a move in the entire segment? It is much smarter to play the segment -- and if you want the volatility you get with an individual stock, you can buy a call or a put.

• Technical Purity - ETFs are the purest way to mirror the movement of a market segment such as financials or oil stocks and new ETFs are added literally every week. Many of these ETFs have options and liquidity in these options is increasing every hour. The charts on these ETFs typically have nicely sloped charts that are easy to read, easy to trade -- making options trading less volatile and easier to manage.

• A New Efficient Tool - Buying an ETF to go long (or short) a market segment means you have an opinion about that segment. So why limit yourself, and the ability to make money on this opinion to just the ETF itself? You buy options on stocks or the market, and more and more this activity is migrating from your trading or play money account to your serious trading or investment account. Why not expand your horizons to entire market segments, a much more efficient and potentially profitable approach? 
  

• Minimizing Volatility - If you want to minimize the volatility of a position, ETFs can help, and puts and calls on ETFs do the same. An individual semiconductor stock may move 10%-33% on a given day -- for or against you -- based on news and headlines. If you think chips, in general, are headed one way or another, you play the ETF -- in this case, calls on the ETF -- and they will turn out to be far less volatile than an individual stock. This eliminates surprise news having too great an impact on an individual position.

• Maximizing Volatility - If you want to maximize volatility, puts and calls on ETFs are the way to go. A 3% drop in the Dow Jones Financial Index equates to a 6% gain in the ProShares UltraShort ETF (SKF) which, in turn, would probably generate a 40%-75% gain in selected calls for that ETF. Not bad for a 3% move in the index, far more than you would get if an individual bank stock went down 3%.Recently double short ETFs have diverged significantly from their underlying indices. For this reason they are not being recommended. And here are five reasons why buying puts and calls on ETFs can be more profitable than options on stocks or entire market indices.

• Reinforcing A Profitable Belief - ETFs let you play a belief, such as the price of oil is going up or down. A double-short or double-long ETF reinforces that opinion in a highly efficient manner -- when oil goes up a dollar, your ETF goes up or down two dollars. So it follows that a call on a long ETF on oil means you really see oil prices going up, and a put means you really believe they are really going down. Options on ETFs, while quite risky, are the cheapest and most-efficient way to reinforce a belief in a position in the market -- and potentially the most profitable.

• Quickly Playing Trends For Profits - A call or a put on an ETF enables you to play a trend -- such as the banks are falling or the banks are rising -- without investigating the fundamentals or the charts of a dozen or more companies. I don’t recommend it but they are also a way to play a binary event like a major headline everyone knows is coming -- an election, the passage of the Troubled Assets Relief Program (TARP) and so on -- something that has a major impact on a market segment. And get in and out quickly and very profitably if you are right.

• Playing For Long-Term Profits - ETFs are a great way to play the long-term, underlying fundamentals of a market segment. If you think oil is going up, you can buy calls on an oil ETF or sell puts -- you won’t mind being “put” the ETF as you are convinced it is a good long-term play. And you can buy them months out and “roll” them into longer-term positions as needed -- tying up much less capital than purchasing an individual stock or ETF, but generating greater profits.

• More Positions, More Profits - Using puts and calls extends the reach of your trading account or portfolio, and this is multiplied by an order of magnitude when using puts and calls on ETFs. If you think three related market segments will be hit by a recession -- consumer spending, retail spending and housing, for example -- there are ETFs on all three and you can use a relatively small part of your account to play these segments and generate large profits compared to owning individual ETFs or even options on stocks.

• Rocket-Fueled Trades - A rewarding (but risky) trade is buying a call on an inverse or short ETF. These ETFs are designed to move as an index or underlying commodity moves. Given recent anomalies in the prices of double-inverse ETFs, this trade can produce the best short-term gains when you want to short a market segment, even though it has a lot of volatility and more risk than other trades. Consider this scenario: You think three major banks -- Citi (C), Bank of America (BAC) and Wells Fargo (WFC) -- are going to surprise with worse-than-expected earnings. You buy calls on the Short Financials ProShares (SEF) –- the short ETF for financials-– and you hang on for the ride. Although premiums seem stiff, a 5% down move in the financials means a 5% up move on the ETF and perhaps a 40 % up move in the call. That's an eightfold increase in profits, thanks to the leverage provided by the call.

Before you do any of this, make sure the puts and calls on an ETF are liquid and don't be put off by spreads, they are wider than for most options on stocks. Use limit orders and, well, you know the rest.

Good luck trading.