Over the last twenty years, exchanges and brokerages have created hundreds of new products that behave like groups of stocks. Companies like Vanguard, Fidelity and MorningStar sell these to investors, who use them to diversify their portfolios or hedge against loss. These tradeable products include Indexes, ETFs and ADRs; some come with options.
The most popular Indexes/Indices have products which mimic large portions of the market such as the
- DJIA is the Dow Jones Industrial Average of 30 key stocks
- SPX indexes the whole 500 stocks of the Standard & Poors 500
- NDX lists the key technology stocks
- RUT or Russell 2000 represents 2,000 small-cap stocks
But some of these indices are huge, so new trading vehicles enable investors to trade more convenient trade sizes. Here are some important things to know about ETFs and their sister indices:
- DIA represents the DJIA
- SPY options closely represent 1/10 of a SPX
- IWM options closely represent 1/10 of a .RUT
- QQQ options closely represent 1/40 of an .NDX
Some are cross sectional, representing large cap, mid-cap or small cap stocks. Others reflect industry segments such as healthcare (IBB) or Global Retail Development Index (GRDI). GLD is a controversial ETF linked to the price of gold, and usually reflects the London gold fix.
Many ETFs and Indexes are weighted, meaning the underlying stocks are chosen carefully and proportioned to reflect the fund goals. For example, if a stock doubles in value over a few years, it might be trimmed by a similar proportion to other stocks in the index. Some indexes such as the RUT periodically "rebalance" and throw out the poorest performers.
As there are hundreds of these, we can only guide options traders by offering some criteria for trading:
- optionable
- liquidity and acceptable bid/ask spreads (under 5%)
- close strikes
- beta in the 1 to 2 range
For a guide to using the SPY in the current market, read this blog and others in the series.
The VIX
Short for "volatility index", the VIX reflects the overall price of options. When the VIX is under 16, the market is abating risk, when it is over 16, it is expressing more risk. Scores above 20 represent 
periods of high anxiety and below 12 suggest market is not concerned about prices dropping. We use these patterns to predict next moves in the market. (In the image here, prices close to the yellow lines represented extremes of low and high volatility. )
HOMEWORK
- Read Chapter 13, "Benefitting from Exchange-Traded Funds" in Trading Options for Dummies.
- Choose five ETFs with options and begin to trade them.
- Place trades for the QQQ, RUT, and SPY and compare their performance.
All rights reserved worldwide.
Copyright 2014-2016 Honolulu Options Traders, LLC