Q&A

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Explore Your Options

Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the STOCKS & COMMODITIES website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C.

Tom Gentile of Optionetics

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ETFS 101

What are ETFs? Can you give me a quick ETF 101 course?

"ETF" is short for "exchange traded fund." These investment vehicles trade on the US stock exchanges, mostly the American Stock Exchange. Each ETF holds a group or basket of stocks. Some hold the same stocks that make up a popular index. For example, the Dow Jones diamonds (DIA) is an ETF that holds the same 30 stocks as the Dow Jones Industrial Average (DJIA).

Other ETFs are created to track specific sectors or asset classes. The Semiconductor HOLDRS (SMH) is an example of a popular sector fund. As another example, the iShares Russell 2000 Small Cap Etf (IWM) is one of the most actively traded ETFs today. It holds shares of smaller companies (by market value).

There are literally thousands of ETFs to choose from today. One way to start is to look for lists of the most actively traded exchange traded funds and ETF options. The information is available on popular websites, including the investing section of Yahoo! Finance as well as the exchanges where ETF options trade (the Chicago Board Options Exchange, the American Stock Exchange, the International Securities Exchange, and the Philadelphia Stock Exchange).

I trade ETFs for a number of reasons. Since many are actively traded and have vibrant option markets, the liquidity is good and it's easy to get in and out of large positions. In addition, shares can be bought as well as sold short. Therefore, ETFs like the Dow diamonds or S&P Depositary Receipts (SPDRS) offer a way to go long and short, as well as a variety of opportunities for trading and adjusting advanced strategies like butterflies and condors.

Any broker that offers stocks will also offer exchange traded funds. The process of buying and selling shares is the same for both. In addition, if the firm offers trading in stock and index options, it will also offer ETF options. However, just as with trading stock options, it also requires the customer to submit an option approval account form.

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WHEN TO EXIT THE BUTTERFLY

Say I have a 300-310-320 butterfly on XYZ. If the stock hovers around 310 with two weeks left until expiration, should I take any profits available or wait it out and try to get maximum profit? Is it worth the risk? Or if I have a butterfly spread with the underlying moving too fast in the right direction, should I wait for a reversal or close out the trade?

Great questions. I have always believed that it is imperative to have an exit strategy in place before you enter the trade. Having a plan will keep you emotionally unattached regardless of the outcome. By having your plan in place, you will know what to do whether you're right or wrong. This applies to all strategies, even simple ones like buying shares or call options.

In the case of the butterfly spread, the goal is to take advantage of time decay. For example, if XYZ is trading for $305 and I expect a gradual move to $310 between now and January expiration (60 days), I might sell two of the January 310 calls for $4, buy a January 300 call for $7.50, and buy a January 320 call for $2.50. If so, I have entered a butterfly spread. Ideally, XYZ will move to $310 and the short calls (which are held short) will lose value. The 320 call will also lose value, but the 300 calls, which were already in the money when I opened the trade, will hold steady and perhaps increase in value.

Let's put some numbers to it. In most cases, the butterfly spread is entered for a debit. In the example, I receive $8 for selling the two short calls ($4 per contract), but pay $10 net for the calls with the higher strike ($7.50) and lower strike ($2.50). The debit is $2 ($10 - $8) and this $2 is the risk for the butterfly. My payoff potential is the difference between the two strike prices and the debit. The difference between the strike prices is 10 (320 - 310) and the debit is $2 and so my maximum payoff is $8 per butterfly, which happens if XYZ closes at exactly $310 at expiration.

What are the odds of XYZ closing at precisely $310 a share on the third Friday in January? Not high. Instead, it is more likely to be near the strike. Here's an analogy: When I took golf lessons, the instructor told me to visualize a larger circle one foot around the cup and try to put the ball into the circle rather than aim for the cup itself. Same with a butterfly -- we are not aiming for the maximum payoff but want the stock to move into the range of profitability.

So to answer the question, with two weeks left till expiry, if XYZ is at $310, our profit objective has probably been achieved. Again, the dollar or percent return would have been established prior to entering into the trade. For example, we might have set a target for $6.50 per fly rather than the maximum payoff of $8. To answer the second question, if XYZ blows through the upper strike price of $320, we would have probably triggered a stop-loss at some point. In this case, the trade is not unfolding as we expected. It's time to concede defeat and move on to the next trade.

Finally, scaling out of a trade, whether profitable or unprofitable, is another useful tool when exiting. If I have two butterfly spreads instead of the one outlined here, if the trade is moving in my favor, I might bank profits by closing out one of the flies, but then hold onto the other for another week.

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Originally published in the November 2008 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2008, Technical Analysis, Inc.

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