tastytrade logo
uploaded image

Apr 12, 2017

tasty Opportunity: Sector ETFs vs. SPY

By:Sage Anderson

When selling volatility, exchange-traded-funds (ETFs) can be particularly appealing because they reduce stock-specific risk.

For example, if you sell a straddle in SNAP, one risk is that the stock makes a big move (up or down) during the time you hold the position. Hypothetically speaking, a big move could occur due to financial problems, legal problems, or a takeout.

ETFs reduce single-stock risks because they are composed of more than one stock, in most cases many stocks. Consequently, if there is a blow-up in one company within an ETF, the effect on a short volatility position is minimized (as compared to being short volatility in the single-stock alone).

You may already have a process for filtering the ETF universe for trading ideas, but if not, a recent episode of Market Measures may be of interest. This episode focuses on the sector ETFs, and their relationship to the broader S&P 500 ETF (SPY).

The sector ETFs are the 10 unique funds that divide up the S&P 500 by business category/focus. The sector ETFs include:

  • XLY - Consumer Discretionary

  • XLP - Consumer Staples

  • XLE - Energy

  • XLF - Financials

  • XLV - Health Care

  • XLI - Industrials

  • XLB - Materials

  • XLRE - Real Estate

  • XLK - Technology

  • XLU - Utilities

The existence of sector ETFs provides traders with additional choices when evaluating trades that may better express their view. For example, a trader looking to deploy risk related to the financial sector may feel that the SPY is too broad to express this view, while JPM (a single-stock) is too narrow - and ultimately decide that the XLF best fits his/her needs.

If the trade idea was even more specific, a niche ETF like IAT (regional bank focus) could also be a consideration.

Getting back to the episode, the Market Measures team analyzes correlations between SPY and its ten sector ETFs. Then, they discuss trade ideas related to the spread between SPY implied volatility and sector ETF implied volatility.

The assumption made is that if there exists a high correlation between the SPY and one of the sector ETFs, then there will also be a correlation between the implied volatility of the two.

They then use this criterion as an additional factor to consider when deciding which ETF might be the most appropriate to fit their investment goals.

For example, the XLI (Industrial ETF) showed a relatively high correlation of .95 with SPY. Digging a bit deeper, the team then looked at the spread between SPY implied volatility and XLI volatility, which is illustrated below:

As you can see from the above graphic, the spread between SPY implied volatility and XLI implied volatility is constantly moving.

Therefore, when considering trade ideas in sector ETFs, it may be worth referencing this data. Depending on your approach and risk profile, selling premium in a sector ETF may be more suitable when this spread is high relative to the average.

Certainly, evaluating this type of data to see which sector ETFs have the highest implied volatility relative to the historical spread with SPY may provide at least some insight into current market dynamics.

We recommend viewing the complete episode of Market Measures focusing on sector ETFs and their relationship to SPY when your schedule allows.

Don't hesitate to hit us up with any questions at support@tastytrade.com.

Your feedback helps immensely with our goal to provide timely and relevant articles and shows!

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.

Related Posts

tastytrade content is provided solely by tastytrade, Inc. (“tastytrade”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, transaction or investment strategy is suitable for any person. Trading securities can involve high risk and the loss of any funds invested. tastytrade, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors, and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastytrade is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparison, statistics, or other technical data, if applicable, will be supplied upon request. tastytrade is not a licensed financial advisor, registered investment advisor, or a registered broker-dealer. Options, futures and futures options are not suitable for all investors. Prior to trading securities products, please read the Characteristics and Risks of Standardized Options and the Risk Disclosure for Futures and Options found on tastyworks.com. 

tastytrade is a trademark/servicemark owned by tastytrade.

tastyworks, Inc. ("tastyworks") is a registered broker-dealer and member of FINRA, NFA and SIPC. tastyworks offers self-directed brokerage accounts to its customers. tastyworks does not give financial or trading advice nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastyworks’ systems, services or products. tastyworks is a wholly owned subsidiary of tastytrade, Inc (“tastytrade”).

tastyworks, Inc. (“tastyworks”) has entered into a Marketing Agreement with tastytrade (“Marketing Agent”) whereby tastyworks pays compensation to Marketing Agent to recommend tastyworks’ brokerage services. The existence of this Marketing Agreement should not be deemed as an endorsement or recommendation of Marketing Agent by tastyworks. tastytrade is the parent company of tastyworks. tastyworks and Marketing Agent are separate entities with their own products and services. tastytrade has different privacy policies than tastyworks.

Quiet Foundation, Inc. (“Quiet Foundation”) is a wholly-owned subsidiary of tastytrade The information on quietfoundation.com is intended for U.S. residents only. All investing involves the risk of loss. Past performance is not a guarantee of future results. Quiet Foundation does not make suitability determinations, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of Quiet Foundation’s systems, services or products.

© copyright 2013 – 2022 tastytrade. All Rights Reserved. Applicable portions of the Terms of use on tastytrade.com apply. Reproduction, adaptation, distribution, public display, exhibition for profit, or storage in any electronic storage media in whole or in part is prohibited under penalty of law, provided that you may download tastytrade’s podcasts as necessary to view for personal use.