If you're just getting started in the volatility trading realm, or you're thinking about retooling your approach, a recent episode of Tasty Bites will be of interest.
This installment of Tasty Bites focuses on exchange-traded funds (ETFs), and why they serve as such a valuable tool for traders in the volatility space.
As outlined on the show, ETFs tend to be liquid securities. Here at tastytrade, we seek underlying symbols with deep liquidity to ensure we can always trade out of a position without giving up a ton of edge in the bid-ask spread.
Theoretically, symbols with above average liquidity are also less susceptible to market snafus that result from errant orders or technical problems in the market. The sheer volume and capital required to move highly liquid securities makes them quite a different animal than low volume and/or small market cap symbols.
It's true of course that not all ETFs are high volume, so it's important to filter appropriately in the ETF universe when seeking liquidity.
Another important dimension of ETFs is that exposure in these products reduces one's portfolio to unsystematic risk as compared to single stocks. Unsystematic risk typically affects only one company (or a handful), while systematic risk is much wider ranging.
Because ETFs are comprised of a great number of companies, the overall risk of a disastrous (i.e. stock moving) event is reduced. Alternatively, trading volatility in single stocks opens a portfolio to concentrated risk in only a single entity.
For example the XLK (technology ETF) has 70+ holdings represented by a wide swath of companies in the technology sector. If any one of these companies runs into serious problems, the ETF as a whole isn't going to drop precipitously. Alternatively, holding concentrated downside risk in one single company can be a lot more precarious.
After liquidity and diversification, there are several other considerations that play a big role in why we often choose ETFs for volatility trading here at tastytrade.
It probably won't surprise you to hear that single stocks typically trade at higher levels of implied volatility than ETFs - due the risk factors outlined above. Likewise, Implied Volatility Rank (IVR) is also often higher in single stocks.
While that may appear as an attractive opportunity on the surface, other dimensions of the data must be considered. Absolute levels of IV and IVR aren't always indicators of a good trade, or one that is suitable for your portfolio.
While single stocks may offer higher implied volatility, tastytrade research shows that ETFs stay within their expected move a higher percentage of the time than single stocks. The graphic below illustrates the percentage of time ETFs stay within their expected move versus single stocks:
As you can see in the above chart, ETFs have historically stayed within their expected range 76% of the time - approximately 6% more than single stocks. Combining that statistic with the fact that ETFs offer diversification and liquidity helps paint a more complete picture as to why these products are included so frequently in volatility portfolios - especially for premium sellers.
Given that this topic represents virtually a bedrock of the tastytrade volatility approach, we hope you’ll take the time to review the complete episode of Tasty Bites when your schedule allows.
If you have any questions about ETFs, or any other security you might be considering for your portfolio, we hope you’ll leave a message in the space below or reach out directly at email@example.com.
Thanks for reading!
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.
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