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In this brief article I wish to address the issue of adjusting/limiting risk, and enhancing income, for those investors who use Exchange Traded Funds (ETFs) in various market sectors ("consumer cyclicals;" "health care," etc).

A key factor in the effectiveness of any income or hedging strategy is the liquidity of the financial instrument you are trading. Lack of liquidity leads to large bid-ask spreads and lengthy execution times. Both are at least annoying, and at worst, can eat into profits and income generated from a hedging strategy.

Among the most popular sector fund ETFs are those run by Standard and Poor's, the SPDRs select sector funds. Each sector fund relates to an industry or economic group which is familiar with small investors; and each fund has holdings of more than forty or fifty securities, meaning they are not excessively dependent on the fate of one firm, even if they are, by definition, not as diversified as broad ETFs like the SPDRs S&P500 (NYSEARCA:SPY) or SPDRs Dow Jones Industrials (NYSEARCA:DIA). The eight ETFs are:

  • SPDRs Consumer Discretionary (NYSEARCA:XLY)
  • SPDRs Select Technology (NYSEARCA:XLK)
  • SPDRs Industrial Select (NYSEARCA:XLI)
  • SPDRs Energy Select (NYSEARCA:XLE)
  • SPDRs Consumer Staples Select (NYSEARCA:XLP)
  • SPDRs Health Care Select (NYSEARCA:XLV)
  • SPDRs Utility Select (NYSEARCA:XLU) and finally
  • SPDRs Select Financial (NYSEARCA:XLF)

Most of these ETFs trade at least 4 or 5 million shares per day, and often more than that. Thus the ETFs themselves have excellent liquidity and trading features for both short and long term investors. A casual check while I write this article reveals bid-ask spreads of a penny or two in these shares: a very small fraction of a percent, at most.

Surprisingly, this popularity and liquidity does not carry over to the options traded on these ETFs. This is unfortunate, since hedging risk and increasing income (through option premiums) are popular tools with investors in these yield-starved days. But look at the daily volumes and open interest in the options on some these ETFs. For option newbie's, open interest is best described as the "supply of contracts outstanding." It is good measure of overall investor interest. So of course, is volume. Look at the data for just for Calls which expire this November 17th: right around the corner, and therefore most actively traded!

  • XLY: volume about 200 contracts today; open interest less than 10,000.
  • XLK: volume about 1500 contracts; open interest less than 45,000.
  • XLV: volume about 46 contracts; open interest less than 50,000.

Not only is the volume very light in these ETF options, but only a few strike prices are available as well. Thus your hedging choices are limited.

In contrast, look at the broader and more popular SPY: it has traded 175,000 contracts today already, in a wide range of strike prices. And we still have the final frenzied half hour of trading ahead of us! Open interest in the same range of strikes is greater than 350,000 contracts. Bid ask spreads are less than a penny. Comparable numbers can be found for the PowerShares QQQ Trust Series 1 (NASDAQ:QQQ) and DIA, even though today is a semi-holiday with US bond markets closed. .

What does this mean for conservative investors and traders? Many options trade for premiums of $1.00 or even less. The bid ask spread on these thinly traded options can be 4 or 5 cents or more. When a strategy is expected to return only 10% or 15% in premium income (for writers), such a wide spread can consume one third or up to one half of your expected gains. Multiple option strategies such as vertical or calendar spreads, or condors and other exotic combinations, are even more vulnerable.

For speculators buying the options and gunning for triple digit gains, perhaps the bid-ask spread is not as critical a concern. However the lack of liquidity means it can take precious minutes for a trade to be executed, especially since limit orders are essential in thinly traded markets. In addition, slippage often takes place: orders to buy options often have to chase rising asks; offers to sell have to chase falling bid prices. On complex strategies the slippage can be in both directions at the same time. If you try and overcome this problem with limit orders, execution often never takes place.

Thus: for investors and traders looking for ETF options to avoid the volatility and firm-specific risk of individual companies, make sure not only the ETF is actively traded, but that its underlying options are as well.

In future articles I will discuss options on non-stock ETFs such as those which track gold, bonds, or other commodities.

Source: Hedging Market Sector Bets With ETF Options