Magazine article Modern Trader

How to Trade ETF Volatility: Investors Can Diversify into Different Markets through Options on Exchange-Traded Funds. Volatility Analysis Can Point the Way

Magazine article Modern Trader

How to Trade ETF Volatility: Investors Can Diversify into Different Markets through Options on Exchange-Traded Funds. Volatility Analysis Can Point the Way

Article excerpt

Since the first option on an exchange-traded fund (ETF) was launched on the American Stock Exchange in 1998, followed by the Chicago Board Options Exchange in 2000, the market segment has grown steadily in popularity.

Investors now benefit from a wide range of ETF underlyings, from U.S. equity indexes to all kinds of stock-, bond- and commodity-based ETFs. However, quite a few ETF options still exhibit low trading volume. Many ETFs are quite specialized and, therefore, cover specific market segments that interest only a few investors.

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In contrast to more popular options in broad-based equity indexes, these ETF options also are American style; they are physically settled and are subject to early exercise. A proper understanding of the products combined with an analysis of correlation, skew and volatility levels --both implied and realized--uncover opportunities that can supplement any trading plan.

Assessing opportunity

There are many liquid ETF and index options that give investors numerous investment choices. To get a feeling for the option underlyings, "Correlation matrix" (right) lists correlation values for some selected ETFs and equity indexes based on three-month implied volatilities and spot price changes (reported in dollars) based on weekly data for the last three years.

Obviously, the implied volatilities and spot correlation tables look alike because of the relationship between volatility and spot movements. Although those correlations are not stable over time and appear high for this sample, the figures indicate opportunities for investors to diversify their portfolios. Especially interesting is how correlations between commodity-based ETFs and those based on emerging markets are, on average, lower than their correlations with U.S. and European equities.

In "Volatility view" (right), we list some average at-the-money volatility, implied-to-realized spreads and skew figures for some ETFs and equity indexes. Although the three years between March 2009 and November 2012 represent only a short time period, the numbers display some general trends that are observable for longer time series and in other markets, as well: Most notably, on average positive implied-to-realized volatility spreads and high skew levels for equity indexes or equity ETFs.

The positive implied-to-realized spread is a supporting argument for short volatility investments such as, for example, selling short-dated out-of-the-money put options. Because these positions contain delta-positive exposure, they are intended for those investors who expect a neutral to positive performance of the ETF underlying.

With a spot price of around $42 for the iShares Emerging Markets Index, selling a one-month put option with a strike of $38 currently would generate income of around 30

Investors with a more positive view on emerging markets compared to the S&P 500--and who identify S&P 500 volatility as cheap compared to emerging market ETF volatility--may want to take the iShares Emerging Market ETF put premium and buy S&P 500 put options. With a high skew on the S&P 500, investors should select put options that are closer to at-the-money. In this case, the number of long S&P 500 put options should be adjusted to reflect the higher delta of at-the-money options.

Another way to reduce the risk of a short put exposure is a put ratio spread. Investors can profit from a positive skew by adding at-the-money put options on the same underlying to the existing short out-of-the-money option position. The analysis in this case turns from one implied volatility number to the pair of at--vs. out-of-the-money volatilities (see "Skew analysis," page 18). …

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