Last time we discussed the Powershares QQQ (Symbol: QQQQ) ETF and how options trading uses it for broad exposure to movement in the NASDAQ. Today let’s discuss another widely used ETF, the SPDR S&P 500 ETF, otherwise known as the Spyder (Symbol: SPY).

What is the SPY: The SPDR S&P 500 SPY attempts to track the broad S&P 500 index. All equities found in the S&P 500 are found in the SPY ETF.

Why use the SPY: If you notice, the SPY has approximately one tenth the value of the S&P 500 index making it an attractive vehicle to purchase options with for broad based market exposure. The key to the SPY is that most hedge fund managers and others on Wall Street base their performance on the performance of the S&P 500. The SPY, therefore, makes an important tool for hedging portfolios against any drop in the S&P 500 benchmark. From the data I’ve gathered, the SPY is used primarily for hedging but can be used in a bullish sense as well with the S&P 500.

SPY Options Structure: As with the QQQQ, the SPY options are on a $1 strike price interval and trade with as close to $0.01 bid/ask spread.

The SPY is used mainly as a hedge against a dip in the S&P 500. Normally, the SPY is traded in a put options spread limiting rewards but also limiting risks in the event the market maintains a bullish view. As an example, today’s SPY put options had similar volumes at the $150 and $153 strike prices. Using a trade calculator found on OptionsXpress, if one were to purchase a put at the $153 strike price and sell the $150 put, the resulting trade at expiration would create a profit up to $233 per spread traded if the market were to drop below approximately $151 with a potential loss of $67 anywhere above $152. In other words, if the S&P 500 were to correct about 30 points tomorrow, your portfolio would take a hit but would recover some loss through the SPY spread trade.

In my opinion, the SPY should be an integral part of any options trader’s portfolio. With the above example, turning a $67 insurance policy into a $233 payout for downside protection will help you sleep at night.