by Bryan Perry 06/26/08
You might know that you can purchase options on a number of stocks, futures and indexes. But did you know that there are hundreds of Exchange-Traded Funds, and dozens of them have options available for trading.
So what exactly are ETFs? They are a great way to play the market when you want to invest in a particular industry instead of picking individual stocks (or bonds, commodities or currencies) within a single sector.
ETF options function much the same as those on equities, but with some modifications. Similar to stock options, the minimum purchase of ETF options is one contract, and a single contract represents 100 shares of the underlying instrument. But when you're buying options on ETFs, events such as stock dividends and other offerings could result in a contract representing more than 100 shares.
NO NEED TO THROW A BULLSEYE WHEN YOU CAN COVER THE WHOLE BOARD
ETF options offer other benefits, which includes being able to make a smart investment in a sector, rather than trying to pick individual stocks to play and hoping that you choose the right ones.
For example, you might not know which retailers are going to spike in front of a holiday rally (or which ones are going to drop as soon as everyone's scaled back on their spending when their credit card bills arrive in January), so you can look toward something like the Amex SPDR Retail ETF (XRT).
The ETF functions just like an underlying stock, because it represents a collection of individual stocks in a single sector. Accordingly, you can trade calls and puts on it to take advantage of movements in that particular sector.
So, for example, you could buy calls on the XRT as holiday spending is ramping up, and perhaps buy puts on it after the holidays or during other seasonally slow times of the year.
A FEW DIFFERENCES BETWEEN ETF, EQUITY OPTIONS
Something different about ETF options, in comparison with standard stock options, is that they trade in $1 increments and that they are only available during select months during the current year.
For example, if an ETF is trading in the $40 area, you can buy its options at whole strike prices from $39 to $45 (that is, you can buy a call with an exercise price of $42 but not one at the $42.50 level) -- these exercise prices are established to encompass the range that the current market price falls in.
Your broker can point you in the direction of optionable ETFs -- you can trade puts and calls on anything from utilities to pharmaceuticals to financials to leisure-and-entertainment baskets, and a whole lot more.
If you enjoyed this article, check out Bryan's "A 'World' of Option Exercise Types" and "'Earn' Your Trading Stripes This Season."
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