Volatility sucks right now. It feels as if it’s been dying a very slow death over the past few weeks now. ETFs, one of our preferred groups of equity underlyings we like to trade, have low volatility. However, we know that will not last. We believe that volatility is mean reverting. If and when it does come back, ETFs and the individual equities contained within them are likely to see a boost in volatility. Therefore, should we look to trade ETFs or individual stocks if we believe volatility will go up?

To determine which trade is better between trading an ETF or individual stocks comprising an ETF, we ran a study. Specifically, we took a look at selling straddles in the Nasdaq 100 ETF (QQQ), Apple (AAPL), Amazon (AMZN), Facebook (FB) and Microsoft (MSFT). We also looked at results when we held until expiration versus managing winners at 25%.

It is not uncommon to see higher levels of volatility in individual equities vs. ETFs. One reason that happens is because of non-systematic risk and binary events. Binary events are single occurrences which impact a stock’s price. For example, we are currently in earnings season. During this time, we will see volatility rise for a specific stock as its earnings date nears. Once those earnings are announced, volatility will fall.

Binary events have their pluses and minuses. On the positive side, these events can act as an engagement tool by providing a trading opportunity. On the not so positive side, binary events can cause more frequent two and three-standard deviation moves. As a result, this can impact P/L results.

We looked at the results of our study in terms of a percentage of our initial credit received for selling a straddle. In trades that went until expiration, straddles in QQQ were profitable 57% of the time and had the highest average P/L at 5%. The biggest losing trade in QQQ lost 279%; however, that was the smallest loss among the group. AMZN topped the list of biggest losers at 494%.

Rarely do we ever let anything other than milk go until expiration. When we managed our trades at 25% of maximum profit we significantly reduced the amount of losing trades. The percent of profitable trades in QQQ jumped from 57% to 79%. Our average P/L in QQQ increased to 9%. The next best P/L was in FB at 8%.

When tastytraders trade, we are not looking for home runs. We value consistency over all else (it’s why we have salads every damn Thursday). Individual stocks can offer greater profits. They also offer greater potential losses. We have been doing this as long as we have because we avoid those big swings inherent in binary events. Yes, we will trade some binary events because we like the engagement they offer. But those trades are not the core of what we do.   


Josh Fabian has been trading futures and derivatives for more than 25 years.
 

For more on this topic see:

Market Measures | Straddles on ETFs vs. Stocks: July 15, 2016