In the universe of equity options, the main product categories are single-stock derivatives and ETF derivatives.
A key to successfully trading these products is understanding the subtle differences that exist between the two.
Single-stock equity derivatives are the option contracts linked to one single underlying. For example, GE has equity derivatives that trade based on the movement of the GE common stock.
Exchanges Traded Funds, or ETFs, are securities that track an index or a basket of assets. Unlike mutual funds, ETFs trade like common stock on an exchange. ETFs typically have more liquidity and lower fees than mutual fund shares, making them attractive investments.
One of the most liquid ETFs is the one that tracks the S&P 500 index - it is called the Spider and trades under the ticker SPY. However, there are a variety of ETF categories that cover a broad range of investable products.
Sector ETFs are very popular and basically track industries - meaning they are composed of many different stocks competing in a similar industry. Examples include the OIH for oil companies, the XLE for energy companies, the BBH for biotech, and the XLF for financial companies (among many others).
Individual stocks and their associated options carry two kinds of risk - risk to the specific stock and then risk to movements in the broader market. ETFs, which often represent many different companies, therefore face reduced company-specific risk as well as dampened systemic risk due to diversification.
The graphic below shows the lowered risk profile of ETFs as compared to single-stocks through lower absolute implied volatility in the marketplace:
The above slide helps reinforce why premiums in single-stock options are relatively higher than in ETF options. Individual stocks often experience periods of elevated deviation in returns (volatility) which inflates premium.
The risk-reward comparison for single-stock options versus ETF options is therefore on average:
- Single-stocks options: higher risk (volatility), higher reward (premium)
- ETF options: lower risk (volatility) lower reward (premium)
In order to provide further context around the above risk-reward comparison, the tastytrade research team conducted a study to better understand if the higher implied volatility (premium) is justified for single-stock options.
The study involved calculating the absolute daily percentage returns for the S&P 100 stocks and four ETFs (IWM, SPY, QQQ, DIA) in 2015.
Interestingly, this examination revealed that the daily average returns of stocks and ETFs have both hovered around 0% in 2015. However, the path toward these returns was much rockier for individual stocks.
As illustrated below, individual stocks had much larger daily movements and greater variance in returns than ETFs:
The above information highlights the fact that single-stock options and ETF options have very different risk profiles. When selecting a product or strategy, traders need to be cognizant of these differences and make the choice that best fits their risk appetite, capital requirements, and investment goals.
The main takeaways from the above look at single stock and ETFs are therefore:
- Individual equities experience a larger deviation of returns (as compared to ETFs), which is exposure to a different type of risk.
- Returns in ETFs mirror the returns for a basket of stocks, but with much smaller daily variations.
- There is richer premium in the derivative markets of equities compared to baskets of equities (e.g. ETFs).
We invite you to watch the full episode of Market Measures comparing single-stock and ETF options when your schedule allows.
If you have any additional questions or comments, please contact us at firstname.lastname@example.org.
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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.