ETFs Versus Stocks: How Much Market Exposure Do You Want?

ETFs and Stocks When the Chicago Board Options Exchange (CBOE) initiated options trading in 1973, options were available on exactly 16 stocks. These days, there are more than 3,000 stocks, indexes, and exchange-traded funds (ETFs) with available options. Option traders surveying the options-investing landscape enjoy increasing variety and diversity.

They are taking advantage of this diversity as well. In 2010, volume for cleared contracts at the Options Clearing Corporation rose to a new record high of 3.9 billion, 8% above 2009 volume.

There are currently more than 350 optionable exchange-traded funds (ETFs) and HOLDRs. Option traders can now pinpoint specific market sectors on which to place directional trades or created hedged positions. And for those wanting a leveraged investment on the broader market, there are options available on indexes representing the Dow Jones Industrial Average, the S&P 500 Index, the Russell 2000 Index, and others.

Let's briefly review how a trader can think big or small when selecting his stock option picks.

Just the Stocks

Most option traders still gravitate toward individual equities when it comes to options trading. More than 2,500 large-, mid-, and small-cap equities are optionable, from the most omnipresent to the undiscovered potential diamonds in the rough. Traders use options to play direction or volatility, to create complex spread positions, or to potentially finance a stock purchase.

Sector Spotlight

During the past several years, popular market sectors have been compartmentalized into single trading instruments. Shares of these exchange-traded funds (ETFs) or holding company depository receipts (HOLDRs) can be traded in one simple transaction and behave like a stock (minus dividend payouts). ETFs have soared in popularity among options traders. In fact, some broad-based ETFs such as the PowerShares QQQ Trust (QQQQ) and the iShares Russell 2000 Index (IWM) are frequently among the most actively-traded options each day.

For those who are bullish (or bearish) on oil-service stocks, for example, there are several optionable ETFs that play this sector. Traders who already own Pfizer (PFE) shares and want to try and hedge their positions with healthcare puts or covered calls will find ETFs in the healthcare sector as well. Some ETFs even have available LEAPS.

ETFs have been constructed to represent dozens of market segments, from gold producers to Malaysian-based companies to utilities. Just like stocks, however, ETFs used for as the basis for option plays require careful research of fundamentals, historical price trends, volatility shifts, and other indicators.

Wide Exposure

There are certain market environments that might inspire an overall bullish or bearish view. In a situation where a trader's option activity necessitates exposure to the overall market, calls, puts, or spreads using index options are potentially attractive.

There are popular ETFs derived from major indices, such as the SPDR S&P 500 ETF (SPY) or the Dow Jones Industrial Average Index (DJX), which respectively provide exposure to all 500 names in the S&P 500 Index and all 30 names in the Dow. Traders can use these and similar instruments to hedge existing positions or gain exposure to the overall market in one fell swoop.

Most Popular ETFs (In Terms of Trading Volume)

1. SPDR S&P 500 (SPY)

2. iShares Russell 2000 Index (IWM)

3. Financial Select Sector SPDR (XLF)

4. iShares MSCI Emerging Markets Index (EEM) (Diversified Emerging Mkts)

5. PowerShares QQQ (QQQQ)

6. iShares Silver Trust (SLV)

7. United States Natural Gas (UNG)

8. Direxion Daily Financial Bear 3X Shares (FAZ)

9. SPDR Gold Shares (GLD)

10. Direxion Daily Financial Bull 3X Shares (FAS)

11. ProShares UltraShort S&P500 (SDS)