How to Build Your Own ETF with Options
Everyone wants to know where to make the most money in the shortest amount of time. Sometimes, however, it’s just as important to know where you aren’t going to make the fast money — and right now, at least, it’s tough to make money by owning common stock.
As a professional trader with more than two decades of experience, I can think of no greater pleasure than banking sizable gains via a quick trade. It’s just really fun to moving from one position to the next, and to ride the success of your last great trade like Tarzan swinging from vine to vine.
Unfortunately, in a range-bound market it’s hard to trade like Tarzan by just investing in common stocks. So, what’s the better way to invest?
If you’re like me, I suspect you crave just a bit more excitement in your portfolio, and the best way I know of infusing both excitement and a whole lot of potential profits in your portfolio is through options trading.
Through disciplined use of options, you can achieve the same kinds of gains you would typically enjoy from owning stocks in a fast-moving market, but without the long-term time commitment or the intensive capital outlay required with common stock. Of course, before you trade options, you had better have a sound strategy in place.
B.Y.O.O.E. — Build Your Own Options ETF
I am a big fan of exchange-traded funds (ETFs), as they allow you to essentially buy a group of stocks in a particular market sector or wider market segment. But one problem with ETFs is that you have to take the good along with the bad. While some stocks in an ETF might perform well, if there are a few dogs on the list they have the potential to infest that ETF with fleas.
One way to replicate the benefits of owning an ETF is to simply cast a net over the top three to five names in a specific sector. My criteria for findings these names are relatively straightforward: I look for big-volume trading in companies that have had stellar recent quarterly earnings (i.e., they beat estimates, raised forward guidance and maintained/raised their dividend, if they have one).
Once I’ve identified these top companies, I search the available call options on each and then begin to build positions in those with the most attractive strike price and enough trading volume to let me easily move in and out of each position.
By buying call options on the best stocks in a specific industry, I am able to build my own “options ETF” for whatever sector is “hot.” And how do I find hot sectors? Simple — I follow the money.
You see, even on down market days there’s still plenty of money flowing in the markets. Money is constantly leaving troubled industries (e.g., housing and the financials), and moving into high-demand areas (e.g., commodities and health care). By following the money, you can isolate the hottest sectors, and by finding the hottest companies in those sectors and then buying the best call options on each, you can build your own options ETF.
Searching For Gems
Now I know it is easy to say “just find the best companies in the sector,” but sometimes finding those companies is easier said than done. Here’s a short list of some of my favorite techniques for picking the best of the best in a given industry. Follow my advice and you will be able to discover the brightest gems in the stock market.
* Find companies that are reporting blowout earnings and guiding the Street higher for the coming quarters, and even for the year ahead.
* Pick first-tier names that not only are breaking out to new highs, but also those that have no overhead resistance to keep them from pushing higher.
* Uncover those companies positioned in the “catbird seat” — setting themselves apart from their competitors in sales, innovation and market penetration.
* Buy “in the money” calls with plenty of time left before expiration so that you can take advantage of the time premium and give yourself time to ride out any rough patches on the road to profitability.
Buying call options on three to five names in a particular sector not only increases your leveraged exposure in a sector, but it gives you an opportunity to make three to five times the profits as each stock starts to take off.
Even if a stock or two decides not to join their brethren on any significant sector run-up, you’ve done yourself a favor by being in several strong names. And if some of your picks don’t make it, you can sell them with most of their remaining value and then take your money and move on to a new basket of trades.
As with any investment, you always have to do your homework. Your reward comes from carefully selecting those names with the best potential to make money on your terms and in the time frame of your choosing. That’s really what options trading — and building your own options ETF — is all about.
Bryan Perry is the editor of Tactical Trader, an options trading advisory newsletter, and is a contributor to the Options Zone Web site.