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Advantages And Disadvantages Of Options On Etfs And Indexes

By Expert Author: Lucas Lowe

Option tradeable Indexes and ETFs are not subject to the price fluctuations in the same way you see with an individual company and their shares of stock. When an individual company reports an unexpected jump in quarterly earnings or an FDA approval for a drug is delayed, these events influence the stock one way or another. But with ETFs and indexes, up/down earning's reports, gains or losses of contracts, patents, FDA approval, indiscretions by the CEO, or other company successes or setbacks have little or no effect. Each company provides only one ripple within the large pond, and ETFs and indexes move with the industry, sector, or the market as a whole.

EFTs and indexes are comprised of the relative weight of the whole group. One company can falter – drop in stock price – but its fortunes for the moment only minimally affects the ETF or index. Of course, if a stock within the index is a major corporation like Apple or Google, or if the stock is weighted within the index or ETF, it may drop a bit, but not to the degree experienced by the stock itself. This means the ETF or index options carry less risk than the options on an individual company.

If I must put a negative twist on ETFs and indexes, then I'd have to say that because the risk level is less, the level of reward is proportionate. These instruments plod along on surer footing, moving up and down in relative small increments, and without the erratic swings, you sometimes see with some individual stocks. For those who want less risky option opportunities, ETFs and indexes are a surer way to go.

That said, indexes and ETFs on the indexes often have more intraday movement than what is reflected in their closing prices. This often makes them good candidates for trading weeklys. What I mean by this, is there are intraday swings of .75 cents, down and up it goes for a total of .83 cents, yet the end of day close will show a gain of .08 cents.

Sectors

Before we move on and start putting all the pieces together, and since I have referenced sectors several times, let me put them in some understandable context.

The stock market is derived of a number of parts, each reflecting different aspects of the economy, which, as we can see, define a society and all its activities. The U.S. stock market includes collections of industries (usually referred to as sectors) that meet the vast needs of its population. (The World or global market reflects the same group of needs and demands of international countries.)

One way investors classify stocks is by type of business. The idea is to put companies in similar industries together for comparison purposes. Analysts and traders call these groupings "sectors" and you will often read or hear about how certain sector stocks are doing.

Many different stock market data gathering firms, like Investor's Business Daily, have created their own unique sector groupings, but one of the most common classifications breaks the market into 11 different sectors. Investors consider two of the sectors "defensive" and the remaining nine "cyclical." Let's look at these two categories and see what they mean for the individual trader.

Defensive:

Defensive stocks include utilities and consumer staples. These companies usually don’t suffer as much in a market downturn because people are still going to eat and turn on the TV and lights. They provide a balance to portfolios and offer protection in a falling market.

Despite all their safety benefits, defensive stocks usually fail to climb with a rising market for the opposite reasons that they provide protection in a falling market: people don’t use significantly more energy or eat more food.

Defensive stocks do exactly what their name implies, assuming they are well run companies. They give you a cushion for a soft landing in a falling market.

Cyclical stocks:

Cyclical stocks, on the other hand, cover everything else and tend to react to a variety of market conditions that can send them up or down, however when one sector is going up another may be going down.

Here is a list of the nine sectors considered cyclical:

· Basic Materials
· Capital Goods
· Communications
· Consumer Cyclical
· Energy
· Financial
· Health Care
· Technology
· Transportation

Most of these sectors are self-explanatory. They all involve businesses you can readily identify. Investors call them cyclical because they tend to move up and down in relation to businesses cycles or other influences.

There is an interconnectedness to the sectors. Basic materials, for example, include those items used in making other goods – lumber for instance. When the housing market is active, the stock of lumber companies will tend to rise. However, high interest rates might put a damper on home building and reduce the demand for labor.

Each sector is a container holding a variety of industries. For example, the vast Healthcare sector includes businesses involved in medical equipment, hospitals, billing services, pharmaceuticals, HMOs (Healthcare Maintenance Organizations), outpatient and home care, dentists, dental supplies, and hospice care, just to name a few. Each of these industries is comprised of companies (of varying sizes) listed on the stock exchanges.

When a sector is rotating into or out of favor or into or out of its season, the momentum of that move is likely to influence the equities that are included under that particular sector category. You never want to be making investment decisions in a vacuum. By being aware of sector rotation and information, you can see how a stock is doing relative to its peers and that will help you to understand the expected movement of your equity.


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