A recent blog post highlighted an approach to trading the sector ETFs that may have been of interest to tastytraders. Today we are expanding on that topic...

Essentially, the ETF strategy outlined last time seeks to exploit relationships that exist between the SPY (which is an ETF composed of the S&P 500 components) and the sector ETFs, which are the 10 unique funds that divide up the SPY by business category, including: XLY, XLP, XLE, XLF, XLV, XLI, XLB, XLRE, XLK, and XLU.

In the previous post, we focused on the ETFs that showed a high correlation with SPY - meaning when SPY goes up, that particular ETF goes up to a similar degree. Such a relationship can open up opportunities for trading volatility or direction against the SPY.

A recent episode of Options Jive took this analysis of the sector ETFs a step further.

On this episode, the team instead focused on the sector ETFs with correlations to SPY that were at the lower end of the spectrum. This means that if the SPY moves up, the XLE (for example) might move up as well, but to a lesser degree than say XLI (which was one of the most highly correlated to SPY at that time).

What the Options Jive team decided to evaluate was not only the correlation of XLE to SPY (and the fact that it was on the lower end of the spectrum), but also the correlation of XLE implied volatility with SPY implied volatility. So not only the degree to which the two symbols moved together, but also the relationship between implied volatility of the two.

Basically, a high correlation of implied volatility would mean that when SPY implied volatility goes up, then the implied volatility of XLE (for example) goes up to a similar degree.

Such a relationship might indicate that when the spread between absolute implied volatility of SPY and XLE is at extremes (high or low compared to the average spread) there may be an opportunity to trade.

The graphic below shows the dynamic spread between the absolute implied volatility of SPY and XLE (the Energy ETF) over time. The yellow line represents the average spread between the two:

As you can see above, the spread between the absolute volatility of SPY and XLE got as high as roughly 15 points in January 2016 (which incidentally was when oil was experiencing a selloff). After oil stabilized, the spread between SPY and XLE implied volatility dropped significantly to almost zero, which was well below the historical average of roughly 9 points.

Depending on your approach and risk profile, it may be beneficial to look at the spread between implied volatility in SPY and the sector ETF you are considering for a trade. If the spread is on the higher end of the historical range, and you are a seller, it may give you even more confidence that this might be the appropriate course of action.

We recommend reviewing the complete episode of Options Jive when your schedule allows for the best possible understanding of this analysis.

If you have any questions about correlations between SPY and the sector ETFs we hope you'll reach out directly at support@tastytrade.com.

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.