Should You Use Options to Play a Technology ETF?

| About: Technology Select (XLK)

Much of my attention throughout the trading day focuses on the options market. I like to trade and invest in it, but I also think options activity can tell us quite a bit about underlying stocks and sectors. On Wednesday, I received the following update via my subscription to's InPlay.

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And here is the April 25th note referenced above.

Given the wealth of ETF information available to Seeking Alpha readers, I don't need to go into the basics of how they work relative to mutual funds and individual stocks. A play on the Technology Select Sector SPDR (NYSEARCA:XLK) equates, for all intents and purposes, to a play on the Technology Select Sector Index (index ticker: IXT). The following quotes, courtesy of Schwab's StreetSmart Edge, reflect the options activity in XLK reported this month and last by Briefing.

With all ETFs, it's pretty easy to know what you're getting yourself into, as they must post their holdings on a daily basis. With ETFs like XLK, it's more of a no-brainer, given the passive management of the fund. Here's what XLK holds, as of May 10, 2011, according to the SPDR website. You can see that the fund's top ten holdings closely resemble the top ten positions in the index it tracks.

You can use XLK directly as both a trading or investment vehicle. Like all ETFs, it gives you the ability to ride the short-term swings of the area it covers. At the same time, if you believe in the sector, you can make a long-term bullish play. By contrast, you can short the ETF to take advantage of short- or long-term downward movements in tech. Options simply add another layer of possibility to how you can profit from an ETF.

Several one-off events brought the market down on Wednesday (I am writing this in the 2 p.m. hour so it could turn green). Disney's (NYSE:DIS) less-than-impressive Q2 earnings dragged things down at the outset. The guilty verdict in the Rajaratnam trial exerted further downward pressure, particularly on tech stocks. And continued losses in oil and some metals helped hit equities, as of midday Wednesday. Each of these stories represents temporary noise. I think the bull market, namely in tech, remains intact. This sentiment could be what fuels speculation in something like the XLK May $27 calls.

If you look at XLK's price history, courtesy of Yahoo! Finance, the bullish view that $27.00 is in view makes some sense. I would prefer to take that bet to the June $27 calls. With that mind, activity in the May $27 calls could actually be bearish. At this point, I do not know the actual intent behind the volume.

Of course, if you use options to play XLK, you miss out on any dividends it pays. Hopping into near-dated $27 calls, however, could serve as a nice swing trade if you think Wednesday's dip in tech will be short-lived. Consider where the top ten holdings of XLK stand, as of midday Wednesday, thanks again to Yahoo! Finance.

I think there's a lot to like about pretty much every name on that list. I have discussed some of them in previous articles. You have a good mix of old standbys, value plays, and growth stocks. While I might not make an individual bet on all of these stocks, I have no qualms about owning them in conjunction with one another. And, don't forget, you have exposure to tens of other tech stocks, including somewhat considerable positions in names like Hewlett-Packard (NYSE:HPQ), EMC (EMC), Ebay (NASDAQ:EBAY), Visa (NYSE:V), and Dell (NASDAQ:DELL).

To play a temporary or long-term rebound in one or a just a few of those names could be a bit too risky for some investors. This is where the beauty of not only ETFs, given their diversity and flexibility, but options comes into play. For a fraction of the capital it would take to make a sizable bet that tech rebounds this week, throughout May, and into June with XLK directly, you could use options. Each XLK June $27 call contract would cost you about $30, excluding commissions, as of this writing. I feel more than comfortable with a breakeven point of $27.30, particularly if you have no intention of holding the position until options expiration.

If you're long-term bullish on tech, you can trade LEAPS options on XLK. The XLK $26, $27, and $30 January 2013 calls all appear reasonable if you believe the tech names that make up the index XLK strives to mimic, taken together, have room to run over the next 12 to 18 months.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I may initiate a long or short position in AAPL at any time.