Just like every square is a rectangle, every trader is a risk manager.
From this perspective, a recent episode of Market Measures is a must-see for the tastytrade community, which focuses on a very specific risk metric related to options trading.
A company's market capitalization (i.e. market cap) is calculated by multiplying the total number of shares by the current stock price.
While a company's market capitalization is certainly an important piece of data, the risks associated with trading companies across the market cap spectrum is another key consideration and the focus of this episode of Market Measures.
From a business perspective, small companies face different obstacles than larger companies. Small companies are typically focused on growing market share, while large companies may be focused on sustaining, or protecting their market shares.
Smaller companies (i.e. those with relatively lower market caps) also face greater risk as it relates to the broader economy. In the event of a downturn, small cap firms simply don't have the same financial resources at their disposal. Likewise, adverse events can have a greater impact on smaller firms for the same reason.
This is an important consideration for volatility traders, because as managers of risk that can mean that smaller market cap firms inherently carry more dynamic exposure as compared to larger cap firms.
Often times, that added risk translates to higher implied volatility. In fact, a slide from this particular episode of Market Measures illustrates that point very clearly:
While higher implied volatility may sound like the type of reward that is worth the added risk, the above slide doesn't capture the full risk-reward equation. For example, small cap companies tend to trade in bigger ranges than larger cap companies, which means realized volatility is also higher.
Additionally, smaller cap firms have a greater likelihood of being acquired, at least as compared to mega-cap firms like AAPL, GOOG, and XOM. Adverse events, like a poor earnings report, can also make small cap firms move to a greater degree when compared to mid-cap and large-cap firms.
In order to provide even more context on trading small cap companies, the Market Measures team ran a study looking at selling premium in the Russell IWM (which is a small cap index) and compared the performance to selling premium in Dow (DIA), Nasdaq (QQQ), and S&P (SPY).
The backtest included selling 1 standard deviation strangles with 45 days to expiration over the course of 12 years. Interestingly, the small cap IWM did show the highest average profit and percent of profitable trades at expiration.
However, some of that additional upside was certainly linked to the higher implied volatility available to sell in smaller cap stocks.
While the results of this study indicate that selling premium in small cap stocks has been profitable in the past, this topic dovetails extremely well with a recent blog post focused on risk versus reward.
Each and every trader has to identify their own risk profile and accordingly deploy positions and a portfolio management style that mirrors it.
While selling premium in large market cap firms may produce lower returns, it also does so with relatively less risk. Depending on your risk profile, this latter approach may better fit your investment profile.
What's most important is that traders be cognizant of the unique risks presented by small market cap single stocks, and at least be aware of associated exposure prior to entering such positions.
For the best possible understanding of this material we recommend you watch the complete episode of Market Measures focusing on market capitalization when your schedule allows.
If you have any outstanding questions or comments, don't hesitate to send us a message at firstname.lastname@example.org.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.