Date: 12/28/2021
Author: Chris Hood
Be sure to check out new episodes of my video podcast each week, where my ace pupil Brian Jones and I talk the ins and outs of options trading- and give you insights and strategy that you can immediately put to work for you in the markets.
Many highly profitable, professional options traders steer clear of individual stocks.
I can hear your confusion through the monitor.
How does a person make money without trading underlying stocks?
Aren’t options based on stocks?
Ok, let me address the latter question first. Yes, options are derivatives of stocks – they’re contracts to buy or sell shares of underlying equities.
However, an individual stock represents one particular company, and many factors could dramatically affect the stock price.
Some bad press about the company’s CEO might come out after hours so that you wake up to a steep drop.
Your short-duration calls and credit spreads will lie battered and bleeding on the floor with no chance of recovery.
Remember that options trades are time-sensitive, so unlike stock shares, you can’t just hold and wait for a rebound. Timing is critical.
One way to get around this is to focus on the “easy money” in bull markets – trade the indices.
It’s possible to trade cash-settled options directly on an index. However, that’s a topic for another time. Today let’s just consider the ETFs that track market, sector, and subsector indices.
The most commonly traded are those for the S&P 500 (SPY) and its sectors. For example, XLY (consumer discretionary), XLK (technology), and XLV (healthcare).
These ETFs provide exposure to a set of stocks within the sector, with larger companies weighted more heavily.
In our XLY example, AMZN and TSLA combined comprise 41.29% of the sector. Other established companies like MCD, NKE, and LOW contribute just under 5% of the sector’s exposure.
For those who prefer longer-term trends, an index can be much easier to trade for three main reasons.
First, you don’t have to worry about binary events (like earnings) or sudden bad news on a single company wrecking your trades.
Any professional trader will tell you that directional bets on earnings are gambling.
Companies can miss earnings then gap and go on a bull run to the moon. Or they might beat their earnings expectations and sell-off 15% over the next couple of days.
And sometimes, they do nothing.
Hold an options position through earnings, and you’re taking an incredible risk.
There are no earnings to worry about with an index, so it usually isn’t a big issue if one of the constituent companies takes a dive.
The second advantage is that index ETFs are far less volatile than most stocks.
Suppose your trading plan favors directional buying strategies such as long calls or bull call spreads. In that case, you’ll have the benefit of paying less for your positions.
This isn’t to say you can’t sell puts or bull put credit spreads based on pullbacks or momentum. You just won’t get the same premium that you would on stocks with higher implied volatility.
Indeed, this is a trade-off, so index ETF trades often work best for those who prefer to buy rather than sell.
Finally, ETF options give you a less expensive way to trade high-priced companies.
Today, AMZN is trading at $3410.50 per share, and an April 14, 2022 call option at the 3315 strike would cost $27,355.00.
This is simply too rich for most retail traders’ accounts. And if they can afford it, they still probably shouldn’t unless it represents less than 3% of their total account value.
So unless your trading account is around 900K, you’d be taking on far too much risk.
On the other hand, XLY provides a good deal of exposure to AMZN. In fact, the company represents nearly a quarter of the sector’s weight.
Significant movements in AMZN will be translated to substantial, if subdued, price action in XLY.
And trading the sector is much more affordable.
For comparison, XLY is trading at 205.28, and the equivalent call option for April 14, 2022 at the 200 strike cost only $1280.00.
Much better for proper position sizing.
So if you’re having trouble “finding stocks” for your options trades, consider making index ETFs your watchlist staples.
Cheers,
Chris Hood
P.S. – I want to congratulate Corey and his subscribers on their latest TrickShot win of 104.24% on SEAC this week. Small cap stocks are heating up right now and he’s one of the best at finding the next big moves. Click here to find out more.
