Have you ever wondered what makes options trading on ETFs different from trading options on individual stocks? This guide outlines the importance of understanding the differences in order to choose the right strategy for one’s investment goals!
Learn all about what makes stock options and ETF options two different beasts, and what kind of traders are better suited for each of these investment vehicles. We’ll also address when it’s best to trade stock or ETF options and some of the best strategies that traders can use to generate the profit they’re looking for!
What Is Options Trading?
Options are contracts that give the holder the right (not the obligation) to buy or sell an underlying asset, such as an index, stock, or bond, at a certain price and on or before a certain date. The price is known as the strike price, and the date is referred to as the expiration date. Options are a type of derivative, meaning that they are contracts that are based on underlying assets. Their value is determined by the performance of these assets, so traders can buy and sell these contracts to make money on future price movements.
Calls and Puts
When you’re dealing with online option contracts, there are two basic types, and they are called calls and puts. In the context of options trading, calls give the holder the right to buy an asset at the strike price on or before the expiration date, while puts give the holder the right to sell an asset at the strike price on or before the expiration date.
Call Options
- These options give the holder the right to buy the asset that the contract is tied to at a certain strike price on or before the expiration date.
- The maximum loss for a call option is the premium paid to enter the position.
- Traders should buy call options on the assets they’re interested in trading if they envision them increasing in value. If the price of the asset is expected to rise, call options are the way for the trader to make a profit.
- If the price of the asset goes over the strike price, the holder of the call option can exercise the right to buy the asset. Doing so in these conditions results in them buying the asset at a lower strike price and profiting from the difference between the two.
Put Options
- These options give the holder the right to sell the asset that the contract is tied to at a certain strike price on or before the expiration date.
- The maximum loss for a put option is the premium paid to enter the position.
- Traders should buy put options on the assets they’re interested in trading if they envision them decreasing in value. If the price of the asset is expected to fall, put options are the way for the trader to make a profit.
- If the price of the asset falls below the strike price, the holder of the put option can exercise the right to sell the asset. Doing so in these conditions results in them selling the asset at a higher strike price and profiting from the difference between the two.
The Flexibility of Options
Many traders choose to deal with option contracts instead of trading stocks outright, mainly due to the flexibility and leverage that options can provide in the stock market.
Leverage
Options provide traders with leverage, meaning that the option buyer can pay a relatively small price to gain exposure to the market about the options contract’s value. Even though the trader or investor is using a small amount of capital for this exposure, they can see large percentage gains from small and favorable moves in the value of the underlying asset.
Flexibility
Options contracts are known for their flexible nature, allowing traders and investors to make a profit from a variety of scenarios. The contracts can be tailored to the specific needs of the trader and their specific market outlook. They can choose the underlying asset they want to invest in (stocks, bonds, options, or commodities) and adjust elements of the trade like the strike price and the expiration date. Traders can choose long-term or short-term expiration dates to reflect various time horizons.
Other forms of flexibility that come with trading options contracts include the following:
- Speculation: Most options traders use these contracts to speculate on the future movement of the stock or asset prices that they’re trading. Calls can be used to make money when the prices go up, while puts can be used to make money when the prices fall.
- Hedging: Options can be used as a protective hedge against a possible price decline. Using small amounts of capital with put contracts, traders or investors can use this move to profit from a decline in the stock or underlying asset’s price.
- Income Generation: Another form of flexibility for investors using options is that they can generate steady income by selling covered calls or cash-secured puts. They make money from the option’s premium, but they could face assignment risk.
What are ETFs and Individual Stocks?
You’ll find that there’s a major difference between exchange-traded funds and individual stocks. On one hand, ETFs are a basket of securities that track a specific sector or index, while individual stocks represent ownership in a single company and higher returns with more risk involved. We’ll address both of these investment vehicles in more detail below to give you an idea of what they offer to traders and what sets them apart.
ETFs (Exchange-Traded Funds)
These refer to a type of investment fund that is traded on a stock exchange. ETFs are designed to track the performance of a specific index or sector, and they hold a collection of assets like bonds, commodities, or stocks. Unlike mutual funds, ETFs are traded throughout the day on the stock exchange.
Key Advantages of Trading ETFs
- Diversification: Each ETF spreads investments across a wide range of assets, which can ultimately reduce the impact of poor performance that could occur on a single security. ETFs are composed of multiple assets like stocks, bonds, or commodities.
- Transparency: ETFs provide the most portfolio disclosure for traders. They post all portfolio holdings and their weights on the manager’s website each day, so investors or traders can know at all times exactly what they’re holding.
- Liquidity: Compared to mutual funds, ETFs have a lot more liquidity, which makes them a popular choice of investment vehicle. It’s convenient to draw funds from ETFs if you’re in need of cash flow. However, liquidity varies from one ETF type to the next, largely based on the trading volume of the securities involved and the composition of the ETF itself.
- Lower Fees: ETFs are much cheaper to trade than mutual funds, which are actively managed and come with higher fees. The lower fees you get with ETFs are a result of them being passively tracked on a benchmark index and seamlessly traded on an exchange. The fees are deducted from the fund assets and not directly paid by investors.
- Accessibility: ETF traders and investors can access a wide range of investment strategies and markets. It’s not like stock trading, where you’re buying a single asset, but it instead provides access to a portfolio of assets in a single trade. Not only are they super accessible, but ETFs provide instant diversification in one fell swoop.
Individual Stocks
Dealing with individual stocks means that the trader is purchasing only a fraction of an individual company, with each unit of their stocks being referred to as shares. When traders buy individual stocks in a company, they are getting a portion of the company’s assets as they appreciate in value. Stocks offer a wide range of benefits to traders, but there are some drawbacks.
Pros
- Greater Control: Instead of relying on a fund manager’s personal picks, traders who are dealing with individual stocks can pick stocks of companies that they personally believe in, which results in a more customized portfolio of investments. This is a great perk for traders who want to invest in companies whose values they share.
- Tax Advantages: This perk is more the case with longer-term investments, but traders can enjoy some considerable tax benefits through individual stock ownership, which isn’t available for some investment vehicles.
- Potential for Better Returns: The big appeal of trading individual stocks is the ability to enjoy bigger gains if the stock outperforms the market or specific index funds. However, this comes with the flipside of incurring bigger losses, which we’ll address in the cons section.
- Flexibility: Stock traders can enjoy flexibility and liquidity with their investments, as it’s possible to buy or sell stocks at any time during the market hours.
- Reduced Fees: Unlike some of the fees you might pay to trade ETFs or mutual funds, traders who trade stocks can avoid these management or advisory fees, which leads to lower overhead.
Cons
- Bigger Time Commitment: Trading individual stocks requires a lot more time and research. Traders have to figure out which companies they want to invest in, unlike ETFs, which provide exposure to a wide range of assets and investment vehicles right from the get-go.
- Bigger Risks: Any company’s performance can significantly impact your investment, which makes owning individual stocks a volatile affair. The risk you run with these investments is that they can lose a lot of money just as easily as they can generate significantly higher returns.
- Emotional Decision-Making Can Become a Problem: Because individual stock trading can be volatile, it’s much easier for traders or investors to fall into the trap of making trade decisions based on emotions like greed, frustration, or fear.
- Lack of Diversity: This becomes more of a problem if you’re only concentrating your investments on a few individual stocks in a few companies, but trading stocks on an individual basis can result in an investment set that’s not the best in terms of diversification. You can have a more diversified spread going with ETFs.
Key Differences between Trading Options on ETFs vs. Individual Stocks
Now that we’ve filled you in on what trading and investment look like with both exchange-traded funds and individual stocks, let’s do a side-by-side comparison of each to get an accurate picture of what makes these investment vehicles so different from one another. You’ll find that there are some key differences when it comes to how these investments are impacted by market movements, liquidity levels, and implied volatility.
Market Movement
The Key Idea—ETFs are much more diversified and less susceptible to the impacts of market movements, while individual stocks can gain or lose value much more quickly and easily due to similar movements.
Stocks
Individual stocks are influenced by the performance of one company, making them more volatile. Yes, you can make a lot of money with individual stocks, especially if the company you’ve invested with is outperforming the market or index funds. But there’s the chance of stocks not performing well, leaving you vulnerable to big losses.
Exchange Traded Funds
Now let’s take a look at ETFs. Because these are a collection of investment types that are spread across multiple stocks or sectors, ETFs are much better insulated against the effects of price movement, which makes them less volatile but also not as lucrative as individual stocks could be. Where one share price might fall, you might be able to make up for gains in other securities.
Liquidity
The Key Idea—Both stocks and ETFs can be highly liquid assets to trade, but it all depends on certain aspects of each. Stocks’ liquidity is dependent on trading volume or popularity, while ETFs have two layers of liquidity that are a bit more complex to understand.
Stocks
Individual stocks can sometimes offer more liquidity depending on the stock’s popularity and trading volume. Traders will want to focus on aspects of the stock like its trading volume and its bid-ask spread:
- Volume—A high trading volume indicates a large number of active buyers and sellers, which is a key sign that the stock is a liquid one.
- The Bid-Ask Spread—This refers to the difference between what the buyers are willing to pay and what the sellers are asking for the stock. You’ll want to look for a narrow bid-ask spread, which suggests good liquidity as well as a strong agreement on the stock’s value between the buyers and the sellers.
Exchange Traded Funds
ETFs offer the trader two different layers of liquidity, which makes them a highly liquid asset to deal with. Average daily volume is one part of it (the secondary market), and the other factor is the market makers who publish quotes to ensure that there’s a buyer for every seller (the primary market).
- Secondary Market (ETFs) — This is considered the “on-screen” liquidity that most retail traders can view on their brokerage platform of choice. They can view the bid and ask prices of each ETF, but this only represents a small percentage of the actual liquidity that each ETF has.
- Primary Market (ETFs) — Beyond “on-screen” liquidity, there’s the primary options market which is made of authorized participants who directly create new ETF shares (or redeem existing ones from the issuer or the ETF). This primary market is the main mechanism for market makers to adjust the supply of ETF shares based on the current market demand.
Implied Volatility
When it comes to trading stocks and EFTs, implied volatility refers to a forward-looking measure that serves as a reflection of what the market is expecting in terms of future price fluctuations. Historical volatility is a measure that looks at past performance and is not the same thing as implied volatility, which is more of an anticipation of how volatile the underlying asset or stock will be over a specific period in the future.
The Main Point—Individual stocks have a higher rate of implied volatility as they’re naturally an investment that is easily impacted by volatility, for good or bad! ETFs have lower rates of IV due to the diversification element of how they’re structured.
ETFs are designed for traders who are looking for a wide range of market exposure to multiple sectors or stocks with small, initial investments. This design makes ETFs much more resilient to market fluctuations, making implied volatility a lesser issue, at least in comparison to individual stocks. On the other hand, stocks are more susceptible to sharp price movements in volatility, so they are generally seen as an investment type where you’re going to experience higher levels of implied volatility.
Risk and Diversification
The Key Idea—ETFs are stronger on the diversification and risk front because they’re designed to have the investor’s money spread across multiple stocks or sectors. They might not produce the higher returns of stocks, but they also aren’t susceptible to the big losses that come with stocks either.
ETFs provide a built-in level of diversification, potentially reducing the overall risk of options trades. Suppose you have a stock that is hit hard by a risk factor in that specific industry. It doesn’t impact your investment as much as it would with an individual stock because other stocks in other sectors can experience gains that would offset that one loss. Compare this with individual stocks, where the risk is concentrated in one asset, often increasing the potential for both larger gains and losses.
When to Trade Options on ETFs
Along with trading exchange-traded funds, there are also trading options on ETFs. On one hand, you have ETFs, which are primarily traded like stocks (representing ownership in a portfolio of diversified assets). Then you have options contracts, which provide you with the leverage to buy or sell underlying ETFs at a specific strike price and on or before a certain expiration date, just like you would be able to with stocks and other underlying assets.
When is option trading on ETFs a good choice?
- Seeking Stability: It can be advantageous to trade options on ETFs if you’re looking for some increased stability in your portfolio in broader market sectors.
- Taking Advantage of Index or Sector Trends: Another good scenario for trading options on ETFs is when you want to focus on index or sector trends, where you could make some money on price speculation.
- Good for Risk-Averse Traders: Because you’re dealing with a combination of different stocks in a single investment, ETFs are less risky than trading stocks outright. This makes trading options on these ETFs a bit safer, which can be a big appeal for more risk-averse traders.
When to Trade Options on Individual Stocks
Trading options on ETFs isn’t for everyone. It can be much more complex because you’re speculating on the future price movements of a collection of investments instead of buying or selling options on a single stock, the way you would with individual stock options. Generally, trading stock options is better suited for traders who have less experience or skill, while ETF options are better for seasoned investors and professional traders who have a solid understanding of the underlying composition, specific investment strategies, and tracking errors.
In addition to the points we just laid out, there are some other instances where options trading on individual stocks may be more appropriate:
- Volatility Plays: Trading options on stocks is a better choice for traders who want to make money from the market’s volatility levels. Traditional stocks and their prices are more affected by market volatility, for good or bad. This makes them better investments for volatility plays, unlike ETFs, which are better insulated against big price swings.
- Larger Potential Returns: Although trading stock options carries more risk than ETF options, they also offer the promise of bigger returns to the trader or investor if they employ the right strategies or trading techniques.
- Less Complicated Than ETF Options: With stock options, you’re dealing with price speculation around a single stock or underlying asset, whereas ETF options are composed of a collection of investments. Trading stock options is better for investors with a strong understanding of the individual stock’s fundamentals and market movements. It’s much easier to trade around a single stock compared to a collection wrapped into one investment (aka the ETF).
- Better for Short-Term Price Movements or Earnings Events: There are plenty more opportunities to make money trading stocks around these events than there are around ETF options, which aren’t as affected by earnings announcements or price movements that happen as a result of implied volatility.
Strategies for Trading Options on ETFs vs. Individual Stocks
Whether you’re trading options around individual stocks or ETFs, you’ll want to be sure to use the right strategies or trading techniques to secure yourself a profit. The appropriate strategy is going to differ between ETF and stock options, so we’ve outlined the best moves for each to give you a solid idea of the best approach to trading these two different types of options contracts.
Strategies for ETFs
- Covered Calls—The trader is selling a call option on a stock they already own with the intent to generate income and benefit from any sort of price appreciation in the underlying stock. The holder gets a premium from selling the call option while taking on the possible obligation of selling their shares at the strike price if the stock price rises above the strike price before the expiration date. It’s a great move to use if you’re expecting the stock price to either stay stable or rise only by a little bit.
- Protective Puts—The trader buys a put option on a stock they already own, which creates an “insurance policy” against any future price declines with that stock. If the stock price drops, the trader could exercise the put option to sell the stock at the strike price. Losses would then be limited to the difference between the stock’s purchase price and the strike price.
- Iron Condors—This move works best in a sideways market or one where there is low volatility, which makes it a good “neutral” options trading technique. The iron condor’s goal is to profit from the passage of time and the potential decrease in implied volatility—it involves selling a put and call spread at the same time, which is both out-of-the-money.
Strategies for Individual Stocks
- Straddles: This is one of two primary strategies that profit from volatility without having to correctly guess which way the stock price is moving. For instance, a long straddle profit from large price swings in either direction, while the short straddle covers the in-between outcome and secures the trader a profit if the underlying asset’s price remains relatively stable.
- Strangles: This strangle is made when the trader simultaneously buys a call and put options on the same underlying with the same expiration date, but with a different strike price. With this volatility-based strategy, traders are making a profit when the price of the underlying asset moves significantly in either direction and breaks through either the call or the put strike price.
- Long Calls: This is a long-term bullish strategy where the trader expects the price of the underlying asset to increase with time. The long call is a good move on individual stocks that the trade envisions appreciating over time.
- Long Puts: Unlike the bullish long call, the long put strategy allows traders to profit from stocks that are expected to decrease in value in the long term. It’s another great move for trading individual stock options because it can secure profits based on price speculation.
Pros and Cons of Each Approach
In case you’re not interested in reading the entire guide on trading options on stocks or ETFs, we’ve distilled the pros and cons of each type of investing into the lists below. You can decide if trading stocks or ETFs is the best course of action for your trading style and your taste for risk. For a deeper understanding of these pros and cons, you can read our section “What are ETFs and Individual Stocks?”
Pros/Cons of ETFs
Pros
- ETFs offer more diversification benefits as they’re a collection of stocks spread across multiple sectors/industries
- They offer lower risk compared to individual stocks, which are more impacted by volatility or major market events
- ETFs are easier to manage for beginners due to the lower risks involved
- ETFs provide the most portfolio disclosure for traders
- These investments have a lot more liquidity, though it varies from one ETF type to the next
- Lower fees compared to mutual funds as a result of being passively tracked on a benchmark index and seamlessly traded on an exchange
- ETFs let you access a diverse portfolio of assets in a single trade
Cons
- Lower potential returns compared to trading individual stocks or trading stock options
- ETFs and trading ETF options are a less volatile experience than dealing with stocks outright
Pros/Cons of Individual Stocks
Pros
- Trading options on stocks has higher potential returns, especially if the stock outperforms the market or specific index funds
- There are more opportunities for big moves with stocks, considering events like earnings announcements, new regulations, or product rollouts
- Traders who are dealing with individual stocks can pick stocks of companies that they personally believe in, which results in a more customized portfolio of investments
- Enjoy some considerable tax benefits through individual stock ownership
- Stock traders can enjoy flexibility and liquidity with their investments, as it’s possible to buy or sell stocks at any time during the market hours
- Trading stocks and options on stocks can avoid these management or advisory fees, which leads to lower overhead
Cons
- Trading options on stocks is a higher-risk scenario that’s marked by a more unpredictable trading environment
- Trading stocks on ETFs can be a bit easier to predict due to them not being as affected by market events and volatility—trading options on stocks can be much harder to predict, even though you’re dealing with one underlying asset
How to Choose Between ETFs and Individual Stocks for Options Trading
If you’re unsure if you want to trade options on stocks or ETFs, we’ve outlined a few ways you can tell which one is the right investment vehicle for your trading plan and your future goals.
- Risk Tolerance—Although easier to understand, trading stock options is a much riskier proposition than trading ETF options (which are well-diversified and a good hedge investment). Traders who have a low tolerance for risk might want to check out ETF options, though they might have to teach themselves how to successfully trade them to secure a profit.
- Market Outlook—Being a prediction of how a market might behave based on current and anticipated factors, market outlook is more of a crucial element in stock options trading. There are several different ways you can make money in various conditions, but it all depends on using the right strategies.
- Trading Style—Obviously, traders who are willing to take risks will do better with trading stock options.But what about short-term and long-term trades? Using ETF options, traders who want a good balance of growth and stability can meet their long-term goals best by choosing ETFs over stocks. Options trading with traditional stocks tend to be better for reaching short-term profit goals by taking advantage of temporary price movements.
- Financial Goals—Long-term financial goals are better met with ETF options where traders have a diversified portfolio of investments. Short-term goals are most easily achieved, on the other hand, with stock options where correct price speculation can secure a profit with some hedging perks.
ETFs vs. Individual Stocks—Which Is Right for You?
Trading stock options involves speculating on where the price of a stock might be moving in the future and making a profit when you’ve correctly predicted the outcome. Using the right strategy is key, and traders can enjoy some hedging benefits through trading stock options and, in some cases, the ability to generate income through premiums gained on sales.
Trading ETF options is more complicated than stock options because the underlying asset you’re dealing with is a collection of diversified investments that are less prone to the effects of market movements and volatility. ETF options are a better vehicle for meeting long-term goals through steady, incremental growth.
The most important factor in deciding if stock options or ETF options are the best course of action is your personal trading preferences and risk tolerance. If you want to reach long-term goals through a steady investment approach and minimal risk, go with ETF options. On the other hand, stock options are a good choice if you have a higher tolerance for risk and want to make some of your short-term goals happen in a quicker timeframe.
Pro Tip: If you still aren’t completely sure which path is for you, we’d suggest trying out both options, trading on ETFs and individual stocks, to gain experience. Many brokerage apps and websites allow their users to paper trade using simulators or demo accounts, to gain some experience without using any real money in a live market.
