Are you interested in learning more about trading ETFs using options? If so, this article is for you!
“Exchange-Traded Funds,” or “ETFs,” are funds that are made up of a “basket” of individual stocks. You can trade them just as you would any stock.
They can be expensive, so using the leveraged power of options trading allows them to be traded with much less money than actually buying them.
Let’s take a closer look at trading ETFs using options.
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Most Traded ETF Options
Some Exchange-Traded Funds contain stocks from a broad group of companies.
Perhaps the most well known is the Standard And Poors 500 Index, or the S&P 500, which is represented by the ETF ticker symbol “SPY”.
This fund contains 500 stocks from a diversified group of companies. The SPY is an excellent gauge of the market as a whole, requiring a lot less capital to invest in rather than buying 500 individual stocks.
Also popular is DIA, the Dow Jones Industrial Average ETF, the IWM for the Russell 2000 index, and the QQQ ETF for the NASDAQ.
These are among the most liquid ETF options and among the most traded ETF option.
Another specific type of Exchange-Traded Fund is the “spider,” or SPDR.
This special type of ETF can focus on specific sectors of the stock market.
This is a way to get diversification within a specific sector at one low price, rather than buying a group of individual stocks in that sector.
There are many other Exchange-Traded Funds that track specific investment strategies, nearly 1,300 in all.
For example, a commodity ETF is designed to track the price of a commodity, such as oil or gold.
An ETF may track foreign market companies, or high technology stocks. For example, WPM is a gold and silver ETF. USO is the crude oil ETF and EEM is emerging markets.
Ten of the most popular sector SPDRs and their ticker symbols are:
- Consumer Discretionary (XLY)
- Consumer Staples (XLP)
- Energy (XLE)
- Financials (XLF)
- Health Care (XLV)
- Industrials (XLI)
- Materials (XLB)
- Real Estate (XLRE)
- Technology (XLK)
- Utilities (LXU)
Trading ETFs Using Options: Lower Risk
ETFs are simple trading funds that reduce investing risk. With ETFs, you can gain exposure to large companies, real estate, or the stock market as a whole.
Diversification is simple. Since ETFs invest your money in many different companies, you own a very small stake in many different businesses, reducing risk should one company have poor performance.
ETFs are less volatile, since they are made up of many stocks.
This also makes them good for option trading, and also because it is less expensive to trade options on ETFs than to buy shares of the stock.
Less risky option strategies to use are bull put credit spreads, if you are neutral to bullish on the ETF, or bear call credit spreads, if you have a bearish opinion.
ETFs stuck in a trading range can be played by using an “iron condor” strategy, which is simply using both a bull put credit spread and a bear call credit spread simultaneously.
When this video was recorded, IWM, the Russell 2000 ETF, has been in a trading range about $25 wide for several months, and we’ve successfully traded iron condors on it several times.
Learning to Trade Options
We recommend purchasing the book “Trading Vertical Option Spreads On Robinhood” by Dan Keen, available on Amazon, for a clear understanding of trading vertical spread options.
The option strategy we will talk about here, namely the iron condor, is constructed using two vertical spreads, a bull put credit spread and a bear call credit spread.
The book will go more in depth on these trades, but we’ll briefly explain the concept of both of them here.
A Look at a Bull Put Credit Spread
A bull put credit spread is constructed by selling one put option (a “short” put) at a strike price that is below the current stock price, and then simultaneously buying another put (a “long” put) at a strike price lower than the short strike.
This will generate a net credit (cash into your account) immediately upon execution, thus the name “credit spread.”
A bull put credit spread is used when you expect a neutral to slightly bullish move in the underlying stock.
Bull put credit spreads are especially good strategies when there is a clear support level.
It is used when a trader believes a stock’s price will not fall below a certain price before the option expires.
Novice option traders like this strategy, because they can make a profit if the stock goes up, goes sideways, or even drops slightly.
What Causes Stock Market Volatility?
Understanding Broken Wing Butterfly Options Trading
Examining a Sample Trade
Let’s look at a sample trade. From our research, we find that XYZ Corporation (or any stock or ETF) has been in a slow up-trend recently, and currently the stock price is $50.24.
We will pick a strike price below $50.24, namely $45, to sell a put option. Our bet is that the stock will stay above $45 during the time the option trade stays in play.
The $45 strike price places us well below the current strike price of $50.24, giving us a nice cushion in case the stock drops a little.
The next strike price below the $45 strike is $40. We will buy a put option with the same expiration date but with a strike price of $40. Both of these puts are “out of the money.”
We select an expiration date about 45 days from now.
For selling the short put (the $45 strike put), we receive a premium of $1.36. For buying the long put (with the $40 strike), we must pay a premium of 49 cents.
This gives us a net credit of 87 cents, which when multiplied by 100 because an option contract controls 100 shares of stock, we receive $87 immediately into our account.
If the stock price goes up, we get to keep the entire $87 credit we received. If the stock price does not move between now and the option’s expiration date, we also get to keep the full $87 credit.
In fact, the stock can drop a little and we will still make a profit, since the break even price is $44.13.
A Look at a Bear Put Credit Spread
Now, the opposite of a bull put credit spread is a “bear call credit spread.” This play bets that the stock price will either stay about where it is or will drop in price before the option expires.
A bear call credit spread contains two calls, with the strike price of the short call placed below the strike price of the long call, and therefore the trade will generate a net cash flow (net credit) when the trade is entered.
The short call generates income, and the long call limits the upside risk, should the stock price turn against you.
Maximum profit will be realized if the stock price stays below the short call so that both options expire worthless, and the investor pockets the full net credit.
A bull put credit spread is a great strategy when our opinion is neutral to slightly bullish on a stock.
A bear call credit spread is perfect for when we are neutral to slightly bearish on a stock.
But often, stocks will trade in a range for a while, bouncing up from a support level and backing down from a resistance ceiling area.
This is a time to consider the iron condor strategy.
A Look at the Iron Condor Strategy
The iron condor is simply an out-of-the-money bull put credit spread and an out-of-the-money bear call credit spread, executed at the same time as one trade.
It is a neutral strategy, used when a stock is trading in a defined range. You can, of course, simply execute a put credit spread and a call credit spread separately.
Trading either a call credit spread and a put credit spread on the same EFT or stock (or using an iron condor), will give you more cash than only trading a call spread or put spread, because you get credit from selling both spreads.
For example, suppose a stock or ETF is currently at $356. It has been trading in a range between about $345 and $370, which are acting as support and resistance levels.
We can build a bull put credit spread that profits as long as the price stays above $345. We can also build a bear call credit spread that profits as long as the price remains below $370.
We will sell a call at the $375 strike price and buy a call at the $380 strike, to reduce risk. This sets our high position.
We will sell a put at the $340 strike and buy a put at the $335 strike for protection.
That sets our low position. We’ll set the expiration dates to be 45 days out. As long as the stock price stays below our $375 short strike and above our $340 strike, we keep the full premium amount from both positions.
As we mentioned, you can bundle these two spread trades into one single trade called an iron condor.
Notice that we placed the two short strike prices a slightly away from the support and resistance levels to allow the stock a wider range in which to fluctuate and still make a profit.
Of course, reducing risk also reduces reward, and premium income from the two credit spreads will be less the further away from current stock price we go.
Keep track of your trades with our Trading Log Book!
In Conclusion: Trading ETFs Using Options
Credit spreads and iron condors may seem a little intimidating to newbie option traders, but they are well worth learning, and aren’t as complicated as they may seem at first.
Many beginning traders use the Robinhood platform, and it recognizes both spread trades as well as iron condors.
Since ETFs typically do not experience the extremely wide price swings that individual stocks can have, credit spreads and iron condors are good strategies to use when trading them.