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Know Your Portfolio: ETF Edition

Aug 3, 2017

By: Sage Anderson

As is often highlighted at tastytrade, it's absolutely critical that traders have the best possible understanding of the risks they are taking.

A recent blog post discussed the importance of matching strategy selection with a trader's unique risk profile. Long story short, the idea revolves around defined risk versus undefined risk, and the different implications of each structure.

Today, we are taking that line of thinking one step further.

Suppose you've selected a strategy that fits your risk profile. How can a trader then select the best product for deploying that strategy?

Choosing the appropriate underlying, and one that matches a trader's outlook/profile, is also an important step in the trade management cycle.

For example, consider crude oil, which hit its 2017 low several weeks ago and has since rebounded. When crude oil prices were plummeting, volatility across the energy sector spiked.

Volatility traders following the energy market likely considered this an opportunity to deploy some short premium exposure. In turn, that put energy-related single-stock and ETF volatility in the crosshairs.

At a high level, single-stock volatility exposure offers a much different risk profile than ETF volatility.

Selling options in a single-stock product means that traders are exposed not only to the prevailing theme in this sector of the market (i.e. oil price movement), but also news events that are specific to one company (i.e. oil discoveries, litigation, earnings, etc...).

Along those lines, the degree of single-stock risk also varies. There's a considerable difference if one sells premium in Exxon Mobil (XOM), which has a market cap above $300 billion, as opposed to selling premium in a small or mid-cap energy company.

A recent episode of Options Jive takes a closer look at the components of some ETF and index products which can help traders better understand the risk in their portfolios. The show includes data related to some of the better-known energy ETFs, which fits well with our crude oil example.

The slide below (from Options Jive) breaks down the components of some larger ETFs, including XOP and XLE from the energy sector:

As you can see from the above, XLE has 34 stocks in the portfolio, but the weighting of the top 3 components (XOM, CVX, SLB) accounts nearly 46% of the entire ETF. That's a fairly high degree of concentration in just a few companies.

On the other hand, the XOP contains 62 stocks in the portfolio, but the top 3 only account for only 7% of the total exposure. Obviously, that makes the XOP more balanced, and less top heavy as compared to XLE.

Going back to the crude oil example, traders considering short premium risk, therefore, have several choices when deploying their preferred exposure - each with a different risk profile.

A trader must first decide if he/she is open to the risks associated with single-stock exposure, and whether that is the optimal method of expressing their market assumption. If not, the trader could then choose from the other available products to identify the most suitable product.

In the case of crude oil, this might boil down to a choice between XLE and XOP. Traders looking for a more diversified underlying might at this point select XOP, because it contains 62 companies, as opposed to the 34 in XLE.

By selecting not only the appropriate strategy, but also the most suitable underlying, the trader has now done his/her utmost to ensure the exposure in their portfolio matches their intent and unique risk profile.

While we have focused specifically on the energy sector in this post, the aforementioned episode of Options Jive takes a much more comprehensive look at this topic. We hope you'll take the time to review the complete episode when your schedule allows.

If you have any comments are questions on this material we hope you'll leave a message below or reach out directly at support@tastytrade.com.

Thanks for being a part of the tastytrade community!
 


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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