How to Trade ETFs: Using Options to Lower Risk
We’ve discussed the fact that eventually the market was going to begin its “race to the 200 day”. This has been something that’s been in the works for over a year as the market became more and more oversold. If in fact this is the beginning of the race to the 200 day, how do you protect your short positions when overbought markets become more overbought as just occurred?
One of the better ways to do this is to trade credit or ratio spreads instead of shorting the ETFs outright.
How do you trade credit spreads? If you believe the SPY is going to drop here, you would sell the slightly out of the money SPY calls and buy an equal amount of calls more out of the money. Therefore your risk is contained to the difference of the two calls minus the credit you took in. A ratio spread is constructed the same way, but you sell more calls than you buy creating more risk but also more potential for larger profits. Each of these strategies is less risky than shorting an ETF outright. The one downside to each is that when you’re right in prediction direction, you’ll likely make less money on the spreads than you would have on the options (there’s pluses and minuses to every strategy and never let anyone tell you otherwise).
As we’ve discussed, there are many ways to trade strategies which have had healthy historical edges. The most aggressive strategies will make the most when you’re right and lose the most when you’re not correct. The least aggressive will likely make less money per trade but will be correct more times and protect you better when a trade goes astray.
Lots of people like to identify and trade directional strategies; they’re more fun. The real money comes though from knowing how to best balance the risk and reward of these directional strategies.
Look at the possibility of adding spread trading to your portfolio In the long run, you’ll likely be happy you have them available to you.
Every day in our Battle Plan we’ll provide you with incisive, before-the-bell commentary and analysis on the day’s markets to help put your trading in context. We’ll give you suggested entries and exits for short term trading opportunities in stocks, ETFs and options that may be only hours away. And we’ll give you what many other people can’t: model-driven percentages so that you know the historical win rate going back to 1995 for every single trade idea-long and short.
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Larry Connors is CEO and Founder of TradingMarkets.com and Connors Research.