ETFs or Options?

Exchange-traded funds, better known as ETFs have exploded in popularity in recent years. They started innocently enough as stocks that tracked the major indices. The first such tracking stock was the Spyders (SPY) introduced in 1993, followed by the Diamonds (DIA) in 1997, and then the Q's (QQQQ) in 1999. These stocks mirror the price movements in the S&P 500, the Dow, and the Nasdaq 100 respectively. So popular have these stocks become that average daily volume for the Spyders is close to 200 million shares! (It's 133 million for the Q's and about 13 million on the Diamonds.)

The tremendous success of these tracking stocks have given rise to a universe of other ETF products. Today, you can find an ETF that mirrors almost anything, including commodities, foreign countries, etc. If there's a mutual fund for it, chances are good there's a corresponding ETF. One of the more interesting ETF families that have emerged in just the past couple of years are the short and the ultra-short ETFs. Short ETFs are designed to mirror the exact opposite movement of their underlying index. That means if the underlying goes down by one percentage point, the short ETF will rise by one percentage point. Ultra-short ETFs go one step further--for every percentage point down in the underlying, the ultra-short ETF will rise by two percentage points. These puppies offer a lot more bang for your buck, and one reason they're now so popular (especially in bear markets) is that anybody can trade them in their IRA accounts. (You don't need a margin account to effectively short stock.)

One popular strategy in bear markets is to buy the short and ultrashort index ETFs, but I got to pondering the question: What's the best strategy--buying the straight ETFs, shorting the opposite EFT, or playing their options? And instead of looking at just bear markets, what about bull markets, too?

To answer that question, I decided to look at the Q's since they're very heavily traded and have a liquid options playing field. First, I'm going to look at the bearish decline in the Q's which began when the stock broke major support at $52 on November 8, 2007. This trend lasted until it broke resistance at $46 on April 18, 2008 and began trending higher until just last week (June 11th) when it fell below major support at $48. Okay, so now we've got two scenarios: Bear Market from 11/8/07 - 4/18/08 and Bull Market from 4/18/08 - 6/11/08. Let's compare strategies.

The Strategies
The first strategy is to simply either buy or short the Q's. The second is to short or buy the QID which is the ultrashort Nasdaq 100 ETF. (Both tracking stocks can be shorted.) The third strategy is to buy calls on the Q's when the market is heading up and buy puts when it's heading down. (I wanted to compare options on the QID but there wasn't enough data--sorry!) In the comparisons that follow, I'll be using equal dollar amounts of $10,000 each. The prices quoted reflect closing prices and commission costs are not included. Here's what I found:

Bear Market Comparision (11/8/07 - 4/18/08)
Strategy #1: Short the Q's.
Short (on 11/8/07): 193 shares @ $51.73/share = $9984.
Cover (on 4/18/08): 193 shares @ $46.71/share = $9015.
Total Gain = $969 for a 9.7% return over the time period.

Strategy #2: Go long the QID.
Buy (on 11/8/07): 258 shares @ $38.64/share = $9195.
Sell (on 4/18/08): 258 shares @ $43.22/share = $11,151.
Total Gain = $1956 for a 21.3% return over the time period.

Strategy #3: Buy shorter term QQQQ Puts.
Buy Jun 50 Puts (on 11/8/07): 25 contracts @ $4.00/contract = $10,000.
Sell Jun 50 Puts (on 4/18/08): 25 contracts @ $3.64/contract = $9100.
Total Gain = -$900 for a -9% return over the period.

Strategy #4: Buy QQQQ LEAP Put options.
Buy 2010 Jan 50 Puts (on 11/8/07): 17 contracts @ $5.70/contract = $9690.
Sell 2010 Jan 50 Puts (on 4/18/08): 17 contracts @ $7.10/contract = $12,070.
Total Gain = $2380 for a 24.6% return over the period.

Bull Market Comparisons (4/18/08 - 6/11/08:
Strategy #1: Buy the Q's.
Buy (on 4/18/08): 214 shares @ $46.71/share = $9996.
Sell (on 6/11/08): 214 shares @ $47.38/share = $10,139.
Total Gain = $143 for a 1.4% return over the time period.

Strategy #2: Short the QID.
Short (on 4/18/08): 231 shares @ $43.22/share = $9984.
Cover (on 6/11/08): 231 shares @ $41.36/share = $9554.
Total Gain = $430 for a 4.3% return over the time period.

Strategy #3: Buy shorter term QQQQ Calls.
Buy Jun 46 Calls (on 4/18/08): 43 contracts @ $2.30/contract = $9890.
Sell Jun 46 Calls (on 6/11/08): 43 contracts @ $1.75/contract = $7525.
Total Gain = -$2365 for a -23.9% return over the period.

Strategy #4: Buy QQQQ LEAP Call options.
Buy 2010 Jan 45 Calls (on 4/18/08): 12 contracts @ $8.20/contract = $9840.
Sell 2010 Jan 45 Calls (on 6/11/08): 12 contracts @ $8.80/contract = $10560.
Total Gain = $720 for a 7.3% return over the period.

Conclusions
Boy, does strategy choice ever make a difference! I wasn't sure what to expect and I'm really glad I went through this exercise. Although we only looked at one instance of a bull and a bear market, I think we can safely draw a few conclusions. Compared with the Q's, playing the QID under both bull and bear market conditions is more advantageous. (You'll need a margin account to short stocks, though.) But the most interesting results are in the options strategies. Playing LEAPS beats all strategies in both markets. The losses incurred by the shorter term options strategy just shows you how much time decay affects the options pricing, which brings me to my caveat: If you're planning on holding an option for a few months or so, buy an option with an expiration date that's at least six to nine months further out. And if you elect to play options, make sure they're fairly liquid. You can usually buy them at a better price and they're easier to unload.

If you elect to go the ultrashort ETF route, keep in mind that as your gains are magnified, so are your losses, so it's best to be very diligent in watching the stock and in setting stop-losses. If you play the Diamonds or the Spyders, you might want to go through a similar exercise. Happy trading!

6/19/08 Added Note: If you want to increase your returns even more, you can trade the index futures. There are now many Emini index futures products that make playing these markets affordable for the retail investor. Because of the high amount of leverage involved, futures can be a very risky endeavor and you can easily lose a substantial amount of money. For more information, contact the Chicago Mercantile Exchange at www.cme.com.