Many traders have discovered the benefits of selling naked options on stocks. Done right, this sometimes-risky strategy can be quite profitable. But selling naked options on exchange-traded funds can reduce your risk. Here's how. Selling naked options on an exchange-traded fund (ETF) has an advantage over selling an individual stock option. In terms of their vulnerability to market surprises, ETFs are usually safer than individual stocks. One stock may take a big hit because of isolated bad news (earnings, litigation, scandals, etc.), but it is less likely that an entire index will suffer.

A case in point is the collapse of Bear Stearns Companies (BSC) in March 2008. BSC is a component of the SPDR Financial sector ETF (XLF). While BSC dropped to 4.81 from 61.58 between March 11 and March 17, the XLF dropped only to 23.45 from 24.76. In percentage terms, the difference is even more striking - 92.2% for BSC vs. a relatively minor 5.3% for the index-based ETF.

Clearly, for the naked put seller, a 5.3% drop is more manageable than a 92.2% drop. That being said, there are about 600 ETFs compared to thousands of stocks, and only the most active and liquid ETFs should be used for selling naked options. Only these ETFs have the tight bid/ask spreads that are necessary for reliable execution results.

The liquidity requirement eliminates most of the ETFs with an average daily volume less than a few thousand shares. Now the question is, which active ETFs should be selected for an optionselling program? An ETF is normally composed of different stocks in a sector. If an individual investor has strong feelings that a certain sector, for example, the oil sector, will continue to do well, then perhaps that individual should just concentrate on that sector. We can compare several ETFs based on quantitative analysis to find those that have the most potential profit per month while still minimizing risk.

COMPARING ETFs

The most active ETFs are shown in "Liquid markets" (right). Although each of these ETFs is liquid enough for an individual trader, the volume figures drop considerably outside of the top three, falling more than 50% again from the fourth to the fifth option on the list.

Usually, when considering a derivative strategy, the best measure of an underlying's effectiveness is the derivative itself. So, in our search for the best ETFs, we will go straight to the options themselves. Here are the rules used to compare the selected ETF options:

1. Naked puts that are 10% out-of-the-money (OTM) will be sold on each ETF

2. Enough shares of each ETF will be sold to produce a potential profit of $1,000

3. The time frame is one month (third Friday to third Friday)

All price data were obtained on May 23, 2008, for the June expiration, which was four weeks away at the time. A performance summary on these five most liquid ETFs is shown in "Profit comparison" (right).

Note that the margin required is not borrowed money like stock margin. It is basically 15% of the underlying market value of the short position. The margin and projected profit will change with market conditions.