Passive investing has exploded in recent years. Investing in broad-market indexes has surged in popularity and costs less than ever before. You can take this approach to the next level by incorporating option trading in addition to index investing. The easiest way to trade options while index investing is with the use of Exchange-Traded Funds (ETFs).
Investors looking for lower-cost, lower-risk investments that offer consistent performance oftentimes find themselves investigating Exchange-Traded Funds (ETFs) and Index funds. Although the similarities between the two can be pretty clear, the differences can be less obvious, leaving investors uncertain about which investment is a better fit for their portfolio.
Index Funds vs. ETFs
ETFs and Index Funds fall under the “indexing” classification, which means they are both passively managed funds invested in a basket of securities designed to track or mirror an underlying index. One of the primary benefits of ETFs and Index Funds is that you can own shares of the fund, rather than having a direct investment in each stock or asset group represented in the fund.
ETFs and Index Funds offer you the benefit of broad exposure to the market without the same risk or expense. However, an understanding of their key differences will be meaningful as you try to maximize the potential of your retirement portfolio.
One of the most significant differences between Index Funds and ETFs is how they are traded.
Index funds are traded like mutual funds. Typically, you must use a mutual fund broker to buy shares of an index fund. Keep in mind, the guidelines for buying Index Funds will vary from broker to broker. Selling them can also be challenging as there are typically liquidation restrictions. The good news is that you can usually buy or sell Index Funds without incurring any transaction costs.
However, Index funds will most likely require a minimum initial investment. For example, the minimum for Vanguard’s AdmiralTM Shares or USAA’s S&P 500 Index Fund Member Shares is $3,000.
Fortunately, some companies are beginning to offer a much lower initial investment. There is also a movement towards making Index Funds easier to trade. But ease of trading is one category in which ETFs clearly come out ahead.
Buying and Selling ETFs
ETFs are traded like stocks. You can easily buy or sell them through your brokerage firm. At most you will pay your typical stock trading commission to trade ETFs, but many of the larger online brokers have a large list of commission-free ETFs representing some of the most common indexes.
Unlike most mutual funds, ETFs do not have a minimum investment. You can buy as few or as many shares as you would like. Trading ETFs is accessible, convenient, and uncomplicated.
Like stocks, ETFs trade intra-day and are continually priced throughout the trading day as supply and demand fluctuates. Index Funds, however, are priced using the net asset value (NAV). All trades of an Index Fund are processed at the close of the trading day when the NAV is calculated.
Index Funds and ETFs are passively managed; therefore, both have much lower expense ratios than actively managed mutual funds. Historically, ETFs have a lower expense than Index Funds, giving them an edge in this area of comparison as well.
Trading Options with ETFs
An added benefit of ETFs is that many have exchange-traded options available. Not only do ETFs provide you with a low-cost way to add diversification to your portfolio, when you combine them with selling options, you can create a powerful way to generate portfolio income and reduce risk.
Best Option Strategies for ETFs
There are four basic strategies you can use to trade options with ETFs. You can buy a call, buy a put, sell a call, or sell a put. If you’ve spent any time learning about the Snider Investment Method, you have probably figured out we aren’t fans of buying options.
When someone is buying options, they’re basically placing a bet that the price of the underlying asset, in this case the ETF, will move before the chosen expiration.
Call buyers take a bullish position. They act out of a belief that the ETF’s price will rise. While put buyers do the exact opposite: they’re betting the price will go down. But when you sell options, you aren’t trying to predict the future direction of price. You are simply using the underlying asset for its potential to produce income.
Covered Calls and ETFs
An effective strategy to generate cash flow from your portfolio and potentially boost your long-term return is selling covered calls. Covered calls are a buy-write approach, whereby you purchase shares of the underlying asset and write a call option against the shares.
You would select a strike price higher than what you pay for your shares. If the price of the ETF increases, your call will likely be exercised, and you will profit from selling your shares. Moreover, if the price does not increase, your call will expire, and you may be able to profit from selling additional calls in the future.
Cash-Secured Puts and ETFs
Cash-secured puts are another approach to trading options with ETFs. When you sell a cash-secured put, you choose an ETF you would like to own. Then you write a put at a strike price lower than the current share price. If the share price declines, your put will most likely be exercised and you will be assigned shares of the ETF.
Keep in mind, the primary goal in selling options is to generate option premium, not necessarily to have the option exercised. With covered calls and cash-secured puts you are paid option premium immediately. That income is yours to keep regardless of whether your options are exercised.
Choosing a Brokerage Firm for ETFs
As previously mentioned, you can buy or sell ETFs on your own through a brokerage firm. While that offers you greater flexibility and control, it also leaves you with a big decision – which brokerage firm should you use?
When it comes to brokerage firms, there is no shortage of choices and fortunately, there are numerous reputable firms out there. For many years, we have recommended Ally Invest (formerly TradeKing) to our clients.
Ally has an impeccable reputation and a track-record of financial stability. Here are three key characteristics you should look for in when you choose a broker:
- Commissions and Fees
While cost is never the only thing to consider, it is definitely an important factor. Ally has very reasonable and competitive trading costs. Stock trades are $4.95 and option trades are $4.95 plus $0.50 per contract. Active traders with accounts over a $100,000 qualify for discounted commissions. Plus, like many other brokers, they have over 500 ETFs that trade commission free.
- Customer Service
Not only is Ally’s customer service team friendly and helpful, it is available 24/7.
- Trading Features
One of the things that is particularly important with option trading is a quality platform. Ally’s site easy to navigate and offers an impressive suite of free tools including scanners, chains, charts, and calculators. Ally also has a history of quick and efficient trade execution, which can have a significant impact on your bottom line when you are trading options.
Option Trading on an Index
Index investing is a great way to diversify your portfolio, keep expenses at a minimum, and achieve “average” returns. (You won’t beat the market, but you won’t underperform either.) While both Index Funds and ETFs can be appropriate in a wide range of portfolios, we prefer the flexibility of trading that ETFs provide as well as the ability to trade options with them to generate a stream of portfolio income. The combination of ETFs and smart options strategies can be a great way to boost the performance of your money.