Since early last year, options trading using exchange-traded funds has been soaring.

In February, the CBOE reported another relatively big spike. So what's going on?

"There were a lot of open positions in put contracts," said Joe Cusick, a market analyst at online broker optionsXpress.

A put contract gives you the right to sell an ETF at a specific price within a certain time frame. As the number of puts in the market spiked in February, "that told us people were getting defensive," Cusick said.

Puts can be used to short the market. But you can also hold a long position and then buy a put option to sell that same ETF, as a way of hedging your bets against market whipsaws.

Cusick says that since both strategies are being widely used today, it's likely that much of the recent ETF options trading is less market-timing and more a means of maintaining market neutrality in volatile times.

"The bigger picture is that we're seeing institutions getting more involved in ETF options because spreads are shrinking," he said. "That means these vehicles that offer increased leverage are attractively priced to the market."

Besides puts, investors are also buying call options on ETFs. It's the flip side of sorts to a put option. It gives you the right to buy an ETF in the future at a pre-determined, set price. As such, calls don't normally provide much protection on the downside. But they can help investors make sure they'll lock in gains in the event their ETF takes off.

Another strategy becoming popular is what's called a collar. That's when a combination of puts and calls are employed to provide both upside and downside insurance, allowing investors to lock in gains on the portfolio.

ETF Options Rising

Options on ETFs didn't become available on the CBOE until the late 1990s. But on a percentage basis, it's ETF options that are attracting the most growth.

In fact, at least in the opening months of 2008, ETF options have surpassed those of more established index options. According to CBOE data, January and February trading of the 25-year-old options on indexes averaged about 992,000 in daily volume. At the same time, ETF options averaged 1.3 million a day. That represented a 124% jump from the same two months of 2007.

"We've seen big growth every year in ETF options," said Matt Moran, vice president of business development at the CBOE. "But all options have been growing. So it's part of a larger pattern we're seeing."

In the past, big jumps in stock options trading could be expected in bull markets. In the bear market years from 2000-2002, index options actually outpaced stock options. Analysts credit that to more emphasis being placed by investors on portfolio management than picking winning stocks.

"In general, you'll see more people use options for defensive purposes in bearish markets," said Moran.

He says growth in ETF options is tied into a few different factors. For one, more education about how to use options as insurance and a means to mitigate risks coincides with retail investors discovering ETFs as diversification tools.

"As ETF assets have grown, a lot of the ETF providers are becoming big believers in options," Moran said. "They've come to us and asked for options to be listed on their new ETFs."

He also believes that more benchmarking tools such as the CBOE's Volatility Index (VIX) are being used by everyday investors to monitor fluctuations in their holdings.

(Interestingly enough, VIX has been higher in the past four months than in the previous three years combined).

Clearly, as an indicator of volatility, when the VIX rises, so does interest in options trading.

Not All ETFs Participating

But the recent surge in ETF options trading is still somewhat confined. Three ETFs have dominated that activity. The latest CBOE figures show that in January and February:

• The iShares Russell 2000 Index Fund (NYSE: IWM) has averaged 395,383 daily options volume, a 97% increase from the same period a year ago.
• PowerShares QQQ (NASDAQ: QQQQ) averaged 268,000 in options trading per day, up 61% compared with the same time last year.
• The SPDRs (AMEX: SPY) averaged 337,000 daily options trades, up 242%.

The next biggest was Financial Select Sector SPDR (AMEX: XLF), which saw a 1,200% leap compared with a year earlier. But it represented a much lower level, about 71,000 trades per day.

So there's a huge drop-off. Perhaps just as interesting, some of the more popular names aren't always the biggest draws in terms of options trading. "More diversified ETFs that lend themselves to being more of buy-and-hold vehicles may have huge asset size, but aren't usually going to be found at the top," noted Moran.

An example he gives is iShares MSCI EAFE Index (NYSE: EFA). "There's definitely more interest in sector plays these days. As a result, if people want to play the sectors and have a limited amount of money to use, ETF options can certainly be an attractive vehicle," Moran said.