The Power of Sector ETFs
Dec 22, 2017
By: Sage Anderson
If you’re searching for new trading ideas, a recent episode of tasty Bites might be a good place to start.
This installment of the popular series focuses on sector ETFs, and serves as an important reminder that this niche of the financial market is rich with opportunity.
While broad market ETFs such as SPY and IWM can be great trading vehicles, the hosts of Tasty Bites remind viewers that they can also be capital intensive. Both SPY and IWM are high-dollar underlying symbols, trading around $265 and $150 respectively.
Like SPY and IWM, the sector ETFs also offer diversification and reduce exposure to unsystematic risk (as compared to single stocks). However, the sector ETFs trade at lower absolute prices, making them more accessible from a capital perspective.
As a reminder, the sector ETFs are a class of exchange-traded funds that invest in the stocks and securities of a specific sector, typically identified in the title of the fund. For example, the XLF is called the "Financial Select SPDR ETF," and is comprised of 62 underlying symbols that operate in the financial sector and are represented in the S&P 500.
Below are some of the best-known sector ETFs (including price and number of components):
Financials (XLF): Price: $26 Components: 62
Technology (XLK): Price: $62 Components: 72
Consumer (XLY): Price: $92 Components: 85
Health Care (XLV): Price: $82 Components: 59
Industrials (XLI): Price: $70 Components: 68
Retail (XRT): Price: $39 Components: 101
As you can see in the bullet points above, the lower absolute prices of the sector ETFs means that less capital is required when trading in these products as compared to SPY or IWM. The reason is that the higher the price of the ETF, the higher the capital requirement for short option positions. On the other hand, the higher the price of the ETF, the higher the price of their options, all other things being equal. The profit relative to the capital requirement is almost the same. So, lower-priced ETFs may be more suitable for smaller sized accounts.
A graphic included on the show highlights how buying power reduction (BPR) is reduced when trading a short straddle in any of the sector ETFs, as compared to SPY.
Traders should also keep in mind a couple other factors that might make the sector ETFs a suitable choice for a volatility portfolio.
First, historical data presented on tasty Bites illustrates that short straddles deployed in the Sector ETFs have consistently exhibited high win rates (on average). The study, introduced on the show, backtested short straddles (45 days-to-expiration) in each of the Sector ETFs and managed trades at 25% of maximum profit.
As you can see in the chart below, the success rate was high across the board:
Another important consideration revolves around the fact that traders can cherry-pick the most attractive levels of implied volatility when trading the Sector ETFs, as opposed to only the single blended levels available in SPY or IWM.
For example, using Implied Volatility Rank (IVR), traders can look at all of the sector ETFs and evaluate on an individual basis whether one of them (or more) looks attractive for either long or short premium trading.
You can see below that at the time this snapshot was taken, the XLV and XLI both had IVRs above 50%. This type of approach can make it easier to identify potential trading ideas for further analysis:
We hope you’ll take the time to review the complete episode of tasty Bites focusing on the power of the sector ETFs when your schedule allows.
If you have any questions about any of the topics included in this post, don’t hesitate to leave us a message in the space below, or reach out directly at firstname.lastname@example.org.
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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