Options are derivatives which means that you need an underlying asset to trade options. This underlying asset can be almost anything. It can be a stock, an ETF, an Index or something else.
But how can you decide what to trade options on? Which is best?
In this article, I will compare different underlying asset types and present the pros and cons of each so that you know what you should trade options on.
Before we dive into the different asset classes, you should be aware of the fact that not every asset is optionable. In other words, not every stock (or other asset) allows you to trade options on it.
So when looking for underlying assets to trade options on, you should obviously be looking for optionable assets.
Let’s begin with stocks. Most major stocks are optionable. Here are the advantages and disadvantages of stocks for options trading:
- Huge Selection: There are thousands if not even millions of different stocks that are optionable. There are endless different stocks to choose from.
- New Opportunities: To the countless already existing stocks there come even more new ones all the time. Big new stocks are coming and leaving all the time. This keeps the market interesting and there probably never will be too few stocks to trade options on.
- Events: Additionally, stocks have events like dividend payments and earnings announcements… This can be a big pro for some option traders because with earnings there can come very good opportunities. This could also be seen as a disadvantage because stock prices tend to move differently around these events. So if you aren’t interested in such events, they can negatively impact certain trading strategies.
- Diversification: Stocks can be a great way to diversify your portfolio because of the amount and variety of stocks.
- Lack of Liquidity: Not all stocks offer the same degree of liquidity. Usually, options are less liquid than the underlying asset. So if a stock has bad liquidity, its options probably are even less liquid.
- Bankruptcy Risk: Different than indexes, stocks can go bankrupt. Even though this is a small risk, it does exist.
Examples of very liquid stocks to trade options on:
BAC (Bank of America)
If you don’t know what market indexes are, I recommend reading my article on market indexes.
Indexes themselves can’t be bought or sold. But this doesn’t mean that you can’t trade options on them.
- Liquidity: Major index options are usually very liquid. Furthermore, there normally is a wide selection of different strike prices and expiration dates for indexes.
- Settled by Cash: As you can’t trade indexes themselves, index options are settled by cash. This means if you exercise an index option, you will receive the difference between the strike price and the indexes’ price instead of shares. This is especially good for option sellers as they can’t be assigned shares when their sold options are exercised.
- Lower Volatility: Usually, indexes are less volatile and therefore, also have lower levels of implied volatility than, for instance, stocks. Depending on the trading style this can be a disadvantage. Depending on the strategy, this could also be seen as a pro.
- Higher Prices: As most major indexes are quite high priced compared to other assets (e.g. most stocks, ETFs), the index options aren’t too cheap either. This means to trade index options, often more buying power is required.
Examples of Indexes to trade options on:
Dow Jones Industrial Average
NASDAQ 100 Index
NASDAQ Composite Index
Russell 2000 Index
Unlike indexes, Exchange Traded Funds (ETFs) can be traded just like stocks. An ETF usually tracks a market sector (e.g. an index, certain stocks, commodities, bonds etc.).
Some ETFs don’t track their assets exactly. For instance, there are some double, triple or even inverse ETFs. This means that these ETFs move double, triple as much or in the opposite direction of their assets.
- Variety: Nowadays, there are many ETFs for practically every market sector.
- Alternative to Indexes: Most major indexes (e.g. the S&P 500) have one or multiple ETFs tracking them. Usually, these ETFs are very popular and very liquid. But these ETFs are priced much lower than indexes. This makes ETF options an ideal alternative to the expensive index options.
- Liquidity: This obviously depends on the ETF. However, most major ETFs are very liquid and also offer very liquid options.
- Diversification: ETFs (and Indexes) often offer integrated diversification because they usually are based on a wide variety of different assets. For instance, the SPY ETF tracks the S&P 500 index which consists of hundreds of different stocks.
- Pricing: Some ETFs that track their assets double, triple, inverse or in another special way can have weird prices. Sometimes, ETFs even have to be repriced if they strive away too far from the assets’ prices that they are tracking.
- Lower Volatility: This also depends on the ETF. But generally, bigger ETFs are less volatile and have lower levels of IV than individual stocks.
Examples of very liquid ETFs to trade options on:
SPY (SPDR S&P 500 ETF Trust).
IWM (iShares Russell 2000 ETF)
QQQ (PowerShares QQQ Trust ETF Series 1)
USO (United States Oil ETF)
EEM (iShares MSCI Emerging Markets ETF)
DIA (SPDR Dow Jones Industrial Average ETF)
Conclusion – What to trade options on?
First of all, there is not one correct answer to this question. As you can see, all of these asset types have their pros and cons. You can’t really go too wrong with any of these. The most important thing is still picking liquid underlying assets and liquid options. Otherwise, I would say it really depends on the current market environment and on personal preferences.
For instance, someone with a smaller account should probably focus on lower priced stocks or ETFs. Generally, index options can require a lot of buying power.
Instead of trying to pick one perfect asset type, you should also consider trading options on multiple asset types. It is a good idea to trade some options on stocks, others on ETFs etc. Diversification is one important part of trading. You should ideally be trading uncorrelated assets and therefore, it can be good to trade option on different asset types.
But in conclusion, I want to make it clear that the underlying asset type itself isn’t really relevant. It is much more important to look at other factors like implied volatility (IV) and liquidity. If you are looking to trade an option selling strategy (e.g. a short Iron condor), one main criterion to look for is high implied volatility (and liquidity).
It doesn’t really matter what asset type it is as long as it matches these criteria.
So one key takeaway from this article is that you shouldn’t focus on the underlying asset too much. Rather focus on that it matches the criteria set by your trading system and strategy.
If you have any other questions or comments, I would be more than happy to answer them in the comment section.
Do you have a favorite asset type or don’t you really care as long as it fulfills certain requirements?
Let me know in the comment section below.
This Article is part of the Intermediate Option Trading Course. If you are reading the article as a part of the course, you can continue to the next lesson: HERE