There are subtle but importance differences between trading these 3 different types of underlyings. In this quick and short video I'll explain the benefits/drawbacks of each style. In particular, we prefer, if possible, to trade ETFs and index options because they have much less "tail risk" and are generally more liquid for entering and exiting.
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In this video tutorial, I want to talk about stocks, indexes, and ETFs. We know there are three main types of underlying securities that we will trade options on.
Regardless of your trading experience, it's important that you understand the benefits and drawbacks of each of these three different types, stocks, indexes and ETFs. That’s what we’re going to go over in this video.
With stocks, here are the main benefits. First, there are thousands of possible companies to trade, and I think the keyword here is “possible companies to trade.”
That doesn’t mean that they’re all great trading opportunities, but there are so, so many different securities out there that we can trade when it comes to stocks, so there’s a lot of choices.
Earnings trading opportunities are huge with stock because they don’t happen on ETFs and indexes, so the ability to trade a stock every quarter around earnings and profit from that implied volatility crush is a huge benefit to trading stocks.
Number three is that there always are new players to trade, so there’s always new companies that are coming out, and they’re going to be hot stocks, and they’re going to have a lot of open interest and volume and liquidity, and they’re going to be great trading vehicles.
Things like right now that are new and still hot are still Twitter and GoPro. Tesla is relatively new to the market, still a very hot stock. These new stocks and companies that come out, they give us more trading opportunities in the market.
Obviously, some of the big drawbacks to trading stocks is the unsystematic risk, so that risk of immediate bankruptcy overnight or a company getting bought out in an M&A deal, something like that that might cause the stock to make a huge gap in one direction.
The lack of liquidity in most cases is a really big problem. Like I said before, there's a lot of companies out there, but they’re not all great trading opportunities.
In fact, probably less than 1% of the market has enough liquidity that we would even be interested in trading that stock and the options on it.
Fewer trading opportunities because generally, there are just fewer companies out there that have options and of those companies that have options available, even less of those companies have options that are liquid and highly traded, so there’s a lot fewer opportunities in stocks.
Then we also do have earnings to contend with, so that throws things through a loop every quarter when we go through that earning cycle.
When we talk about index benefits, I think the biggest benefit to trading indexes is that they’re usually huge and liquid markets.
Everybody trades them, they have a lot of liquidity because they’re used from with institutions and hedge funds and private equity shops, so there’s a lot of market players in there which creates a very deep market.
They’re easy because most of them settle to cash. Indexes like SPX and RUT and NDX all settle to cash, so there’s not a lot of trouble that you have to go through at expiration if your position is in the money or out of the money.
It’s just all settled to cash, so there’s no underlying stock to trade hence. The other major benefit is that it gives us a lot of hedging potential. We often will use in our portfolio the SPY or SPX as a hedge against some of our other positions.
If we get a little bit too overbalanced in one area or another, a little bit too bullish or too bearish, we’ll come in and use one of the major indexes as a way to hedge some of our positions because it’s very liquid, easy to get in and out of and it’s settled in cash.
Some of the major index drawbacks are that option contracts are just larger in value. On the SPX we know this is true, on the RUT we know this is true, NDX we know this is true. Those are just larger valued contracts, so they tend to scare away some of the smaller retail traders.
We also tend to see lower implied volatility because these are index options and they’re baskets of securities. They’re not making dramatic moves up and down every single day; we’re not seeing 5% or 10% moves every other day, so they tend to have overall lower implied volatility which just makes it a little bit harder to trade about getting an edge in the market.
They don’t have the ability to trade earnings on, and that can sometimes be a good thing, but if markets are calm and implied volatility is low, then it's really bad because we can’t trade a lot of stocks, we also can’t trade indexes because implied volatility is low.
We don’t have that potential to trade earnings throughout that low implied volatility market. When we talk about ETF benefits, the first and major benefit of trading an ETF or a basket of securities is that it has less tail risk compared to a single stock.
When we talk about tail risk, that’s the risk that we mentioned earlier in this video, the risk that stock just has a huge move up or down because of a bankruptcy or an M&A deal.
With ETFs, since they’re baskets of securities, they don't tend to see huge moves in one direction or another, and that's why people like to trade them, and that's also a really big benefit.
They’re mostly liquid and have deep markets because if you focus on some of the bigger ETFs, (and there are bigger ETF markets than others) they’re pretty liquid and they have pretty deep markets, meaning there’s a lot of participants at different strike prices, it makes it really beneficial for options traders.
Number three is you can have focused risk across different industries. If we wanted to go in to say financials and just trade financials, instead of doing it in 10 different securities, we could go into an ETF like XLF and trade just focused in the financial sector.
I think that's a really big benefit, is you can target different industries and sectors in your portfolio. Obviously, some of the major drawbacks to ETFs are some of the double and triple inverse choices.
Some of those securities aren’t priced well, and most people don't understand how they're actually priced, we’ve got a video tutorial inside the membership area that goes through how some of those are priced and the errors that are made in pricing that people don’t understand and I think that’s a huge drawback if you trade just those double or triple inverse choices.
In most cases, there are too many illiquid options. Like we said, the ones that are popular have great liquidity, but the ones that are not so popular because there’s a lot of choices, don't have good liquidity at all.
Number three is that re-pricing often occurs and what we tend to see is that in some of these double or triple inverse ETFs, when the security gets so low that it becomes almost non-tradable, they’ll re-price it back up to a higher level and reset the clock all over again.
That just creates a lot of confusion with some of your positions and some of the strike prices that you have and creates a lot of capital requirement issues because now you’re trading a stock that’s 10 or 5 times higher than where it was before. That's a major drawback that you don't see with stocks or indexes.
I hope you guys enjoyed this video just going through these three different categories of underlying that we can trade, both the benefits and the drawbacks. As always, if you have any comments or questions, please ask them right below this video on the lesson page. Happy trading!