Exploring ETF Options

TheStreet.com: We've seen so many ETF products hit the market with a new twist on index tracking, from shorting an index to stock picking within an index based on a specific set of metrics. What's the best way for an investor to wade through the choices and pick an ETF?

Tom Gentile: When it comes to picking an ETF, you're really looking for three things. The first is whether the product fits the person's investment personality, and that means really understanding what a person wants in an investment, how long he plans to invest and how risky the investment can be.

Second, you want something that trades at a decent volume because low-trading volume makes the cost of doing business go up, based on the spread between buying and selling. If you look at something like iShares Nasdaq Biotechnology(IBB) fund, it has volume of over a million and a half shares a day, whereas iShares Russell Microcap Index(IWC), as of just a couple of months ago, was trading 1,500 shares a day. There's a big difference there, and it's reflected in the bids and offers.

Finally, you want to know whether the ETF trades options. An ETF that has options, in general, must have been out on the exchange it trades on for some time, and typically, options won't be on the product unless there's demand to hedge that product. Options are great tools for index investors and could really be an advantage for someone who is trying to hedge against risk.

Can you explain a couple of ways that an investor could use options as an index-trading strategy?

If someone owns a basket of 20 stocks, instead of buying put options on each one of them to hedge against risk, that person could find an index that closely mirrors those securities. Then the investor can buy put options on that index, which is a lot less expensive. For retail investors looking to hedge, this is an excellent and efficient strategy. For someone who wants to speculate on a basket of stocks, using index options is more risk-averse because they're not likely to drop, or go up, 30%, 40% or even 50% in one day. You won't get the same huge price swings you could with a company if you're trading a basket of stocks.