How Correlation Impacts an Option’s Volatility
May 17, 2017
As investors and traders, we live for the next opportunity. Constantly adding high probability of profit positions to our portfolio is how we generate an attractive return on capital.
What's exciting is that new opportunities develop on a daily basis, as markets move and new products come into the market.
As we build on previous experience and add to our skillset, it also becomes easier to recognize attractive risk that that fits our personal risk profile.
It's for this reason that we want to specifically highlight a recent episode of Options Jive, which presents information and historical data that may help you when filtering the market for trade ideas in single stock positions.
As a reminder, single stocks are unique because they are exposed to both systematic and unsystematic risk. In market terms, systematic risk essentially refers to the risk of being in the market and can affect any financial asset.
For example, if a worldwide recession were to develop, almost all of the market would be affected in one way or another. Systematic risk is also called "undiversifiable risk" for this reason.
However, single stocks are additionally exposed to "unsystematic risk," or risk that is specific to one company or industry. For example, if the worldwide supply of lithium suddenly dried up, companies that rely on this resource to make batteries (cell phone manufacturers, electric car manufacturers, etc...) would be dramatically affected, while the broader market would be less exposed.
Due to the added complexity involved in trading single-stock volatility, the aforementioned episode of Options Jive provides valuable insight into metrics traders can use to help find suitable opportunities.
As detailed on Options Jive, the CBOE Implied Correlation Index (KCI) is one metric traders may look to when considering single-stock exposure. Basically, the KCI measures the expected average correlation of price returns in the S&P 500 components - implied through SPX index option prices and the single stock-option prices within it.
Generally speaking, market correlations get higher during market selloffs, which is why these types of markets are often accompanied by an increase in the KCI. From a practical standpoint, consider that when anxiety is heightened market participants discriminate less about which assets to sell - so they all move down. On the other hand, a rise in the S&P 500 will be observed alongside a drop in the KCI.
As you might have already guessed, the KCI is therefore correlated fairly highly to the VIX, with both moving in the opposite direction as the S&P 500.
Now you are likely asking yourself - how does this information help me?
The key point is that as the market falls (which likewise translates to a rising KCI), correlations between index option prices and single-stock option prices are increasing. Given what we know about systematic and unsystematic risk, this might help illustrate why selling index premium may be more attractive during down markets. If implied volatility is high across the board, it’s likely prudent to choose exposure in the assets with “less” risk (i.e. index and ETF options).
Using the same reasoning, when the market is rallying, and the KCI is dropping, this also shows why a decreasing correlation between index options and single-stocks may make the latter group more attractive. In periods of complacency, single-stocks simply have more inherent risk premium available to sell.
It's important to note, that no matter the characterization of the broader market, unsystematic risk is always present in single-stocks, and traders need to be fully cognizant of such risks prior to entering these positions.
tastytrade research presented on Options Jive does provide support for the approach detailed above. Using historical stock and options data from 2007 to present, a study was conducted that examines the relative performance of 8 single-stock positions deployed when VIX was high (above 15), and when VIX was low (15).
Because VIX moves with KCI, this would also translate to periods when the KCI was high and low.
While both approaches achieved an attractive win rate, the results show that (on average) returns were higher in single stock premium sales when the VIX was low (i.e. KCI low) - as you can see in the image below:
It's possible that your risk profile may not allow for trading single-stock options. However, if you are evaluating opportunities in this space, it might be worth checking on current levels in the KCI and consider the overarching themes in the broader equity market to help assist with identifying the appropriate exposures.
Given the importance of this topic, we hope you'll take the time to review the complete episode of Options Jive when your schedule allows.
We also hope you'll follow up with any comments or questions in the space below, or by contacting us directly at email@example.com.
In the meantime, happy trading!
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.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
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