Small Cap Volatility Risk
Mar 26, 2019
By: Sage Anderson
Trading options in single stocks isn't for everyone. Compared to indices and ETFs, there's more absolute risk - which may not fit your strategic approach and risk profile.
Having said that, many derivatives traders embrace single stocks, and couldn't execute their strategies without them.
The reason that risks are heightened when trading single stocks is that they can go bankrupt (i.e stock goes to zero), or they can be taken over (i.e. stock rockets higher). For premium sellers, either of these two scenarios is generally disastrous. Options sellers usually prefer little to no movement, or at least sideways movement in the underlying.
A bankruptcy or takeover obviously represents the opposite.
One important thing to remember is that there are varying levels of risk in single stocks, too. Generally, the size of the company (the total market capitalization) is one metric traders can monitor to ensure the single-stock positions in their portfolio match their risk profile.
Theoretically, companies with extremely large market capitalizations are more insulated from the risk of bankruptcy and takeover. For example, it's hard to imagine anyone trying to buy out Apple or Amazon for over a trillion dollars. Likewise, big companies can better withstand hiccups in their operations, such as a poor business environment, or negative litigation.
On the other end of the spectrum are small capitalized companies. These are generally young, growing companies which are much more susceptible to ebbs and flows in the business cycle, as well as changing consumer trends.
Although financial markets may not be perfectly efficient, they do account (at least partially) for varying degrees of risk across the single stock universe. For example, you'll generally find that implied volatility is higher in small cap stocks, as compared to larger cap stocks, in order to account for the different risk profiles represented by each.
In order to better understand the risk dynamics of single stocks, the Options Jive team conducted fresh research on the topic, which was presented on a new installment of the series.
Before reviewing the research, let's first consider a couple hypotheses regarding the single stock landscape. Because small cap stocks inherently possess more risk, one would think that both implied volatility (the market price of volatility) and historical volatility (realized volatility) would both be higher in small caps when compared to large caps.
However, shouldn't there also be an extra premium paid to option sellers when trading small caps versus large caps? Let's see what the research reveals...
The slide below breaks down the single-stock components of the S&P 500 into 5 tiers based on market capitalization. As you can see in the graphic, implied volatility in the top 100 largest cap stocks in the S&P 500 is on average higher than the other four tiers.
Based on the above, we can confirm that the financial markets do price in additional risk in the options market based on market capitalization, as expected.
Next, let's look at realized volatility (aka historical volatility) across the five tiers of market capitalization and ascertain whether small caps stocks actually move more than their larger cap counterparts.
As you can see in the image below, our hypothesis is once again confirmed - small cap stocks do move with greater historical volatility than larger cap companies. The slide below illustrates the average implied volatility (IV) of each tier, as well as the average realized volatility (RV) of each tier:
Once again, the data can't be disputed. The options of small cap stocks are more expensive than large cap stocks, and also tend to move more (on average) - meaning the added cost is justified.
Now we can take the analysis one step further, and compare the average volatility overstatement (difference between IV and RV) in the five different tiers of companies in the S&P 500 (parsed by size of market capitalization).
Therefore, the average volatility overstatement (calculated as IV - RV) in each tier is as follows:
Taking all of the data that we've examined so far into account, we can now highlight some important takeaways.
First, we can see that the options of small cap companies are more expensive than their larger cap counterparts. However, based on the actual movement experienced by each respective tier, the net difference between the price of the options and the actual value of the options (i.e. the premium overstatement), there seems to be some amiss in the small cap value proposition.
As we can see in the above bullet points, it doesn’t look like premium sellers of small cap stocks are being offered enough incentive (i.e. extra premium) for taking on the heightened risks associated with small cap companies. In fact, referencing the data above, the premium overstatement in large cap stocks is actually higher than small cap stocks, meaning this tier offers greater safety (theoretically) and greater potential reward.
This research is extremely insightful, and should assist volatility traders going forward when evaluating potential opportunities in the single stock universe.
Due to the importance of this research, we hope you'll take the time to review the complete episode of Options Jive when your schedule allows. Traders seeking more information on this topic may find a previous installment of Market Measures dovetails extremely well with the information presented in this blog post.
If you have any questions on market capitalization, or any other trading topic, don't hesitate to contact us at your convenience at firstname.lastname@example.org, or by leaving a message in the space below.
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.
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