The Ins and Outs of Trading Indices and ETF Options
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When you first start out in options trading, you may decide to stick to individual stocks. However, there are other optionable assets besides stocks. No matter what type of trader you are, you will be able to find an ETF (exchange-traded fund) or index that works with your trading needs. These trades will enable you to diversify your portfolio without burdening yourself with a large number of options or stocks – creating an inexpensive way to reduce your risk. First, it is important to understand what ETFs and indices are. An ETF is an investment that has a series of securities that represent a specific index or sector. ETFs are made up of mutual funds but they trade exactly like stocks do. Meanwhile, indices are a statistical collection of stocks that are related to a particular number. As an example, the S&P 500 is made up of U.S. equities, but a stock has to maintain a particular liquidity and market capitalization to warrant inclusion.
How to Trade Indices and ETFs
ETFs and indices trade just as any other option does. As an example, say that you believe there will be a short-term boost in the airline sector. You could buy stock in a single airline and hope for something good. But if something goes terribly wrong with that airline you will miss out on the airline boost completely. This is where indices and ETF options come into play as you may be bullish on a certain sector but also want to safeguard yourself against a weak security in that sector. In this case, you can decide to purchase a call option on the Airline Index.
When you trade an index like this, you will increase your exposure to big players in that sector. Then if the sector is boosted like you predict your profits will be maximized by the call option. In ideal situations, the overall performance of the group will offset the outliers. If the sector does not get a boost, then you will only lose the premium that you paid to get into the trade.
Hedging Your Portfolio with Indices and ETFs
Using an Index or ETF, you can hedge your positions, stock holdings and your portfolio. As an example, say that you decide to short trade a certain stock in the natural gas sector and you are worried that the increasing price of natural gas could defeat your strategy. If you want to hedge against this, you can purchase a United States Natural Gas Fund call option. With this, you can enjoy any boosts in the sector and long option gains will counterbalance the potential losses on the stock you short traded. The premium that you pay for the call option can be thought of as insurance – it is there in case you need it.
On the other hand, say that you are anticipating a phase of short-term vulnerability in the larger equities market. If you want to protect yourself against the losses your portfolio will experience, you can purchase S&P Depository Receipts put option. This ETF will follow the performance of the broader market based on the S&P 500 so the S&P Depository Receipts put option will enable you to capitalize on the weak market as a whole. There really is no reason not to trade indices or ETFs. You can use these options on top of speculation, to hedge your portfolio or stocks holdings or use them in a pairs trade. It can be very useful to you when you have learned about the possibilities of indices and ETF options.
Do you have experience with ETFs and Indices options? How do you trade these options? Please leave your comments below.
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