ETF Futures And Options

In simple terms, an ETF option represents an option on an ETF. Of course, understanding that definition assumes you know what an option is, and what an ETF is.

So, let's break it down a bit. Futures (or options, as they are sometimes called) represent contracts that allow one person to buy or sell something at a predetermined price. They are called "futures" because the transaction is set to take place sometime, well...in the future.

So a typical option might go like this: the buyer has the right to purchase 100 shares of MSFT at $120 in 30 days. The person buying the option can decide to exercise the option, but they don't have to. If the stock is trading at $119 when the option expires, it would be stupid to exercise the option and pay $120. But if the stock is trading at $125, then exercising the option represents a quick potential $5 profit per share.

Okay, so that's an option.

ETF stands for Exchange Trade Fund. It can represent a basket of stocks that cover broad industries or themes. (It doesn't necessarily have to be stocks...some ETFs cover things like bonds as well.)

There's an ETF to track the S&P 500. There's an ETF to track the tobacco industry. There's an ETF to follow biotech stocks. ETFs allow you to buy one financial instrument and have a financial interest in dozens (even hundreds) of stocks or bonds (or whatever)...instant diversification.

So to repeat: an ETF option is an option on an ETF. You have the right (but not the obligation) to buy or sell some number of shares in an ETF at some point in the future at a set price. Just like the option on MSFT, but for an ETF instead.