The market has been unexpectedly quiet through the first couple months of 2017, and while this situation could change at any time, it's possible you are considering some new ideas for your portfolio.
If that is the case, today's post may be the fuel for your creative engine.
In the world of volatility trading, the derivatives products most commonly found in a portfolio are exchange-traded-funds (ETFs) and single-stocks. This is of course in addition to the "pure" volatility products like VIX and VXX.
Unless you are already trading all of the above, it's possible your portfolio may benefit from some exposure that enhances the diversity of your holdings.
But first a little background...
An index (or stock index) is a measurement of a specific section of the market.
Indexes are mathematical constructs, so investors cannot access them directly.
Examples of indexes include the S&P 500 (500 stocks), the Dow Jones Industrial Average (30 stocks), and the Russell 2000 (2000 stocks).
Investors and traders monitor indexes closely because they provide a snapshot of market performance over a period of time (day, month, year).
Exchange-traded-funds (ETFs) were first built to track indexes, but have expanded to track sectors and niche parts of the market as well.
For example, the SPY is an index ETF with components that mirror the S&P 500 index (500 stocks). On the other hand, the XLF is a sector ETF focused on financial companies and is composed of 62 different underlying stocks (such as Goldman Sachs and JPMorgan).
Note that an index ETF counts all the companies in the index among its constituents, whereas a sector ETF only has exposure to a subset of companies operating in that subsector of the market - an important distinction.
Niche ETFs focus on an even smaller slice of the market than sector ETFs. Symbol LIT is an example of a niche ETF - the LIT tracks companies with exposure to the global lithium industry (such as Tesla and FMC Corporation).
It should also be mentioned that ETFs exist for foreign market indexes, foreign currencies, bonds, and commodities - depending on the size and scope of these ETFs they may fall into the index, sector, or niche categories.
Beyond the broad universe of ETFs, investors can also trade options of single-stocks, like those mentioned above - GS, JPM, FMC, and TSLA.
A recent episode of Market Measures highlights some valuable information related to volatility trading in ETFs, with particular emphasis on sector ETFs.
On the show, the best-known sector ETFs are identified and broken down by the number of components, the biggest component, and the weight of the top 5. This information is shown below:
As you can see from the above, the sector ETFs offer different exposure than an index ETF or a single-stock.
For an index ETF like SPY, traders buying/selling volatility in this product are exposed to market-wide changes in volatility. On the other hand, volatility exposure in a sector ETF or a single-stock can be a lot more targeted.
For example, trading premium in the Financial ETF (XLF) prior to an announcement by the US Federal Reserve would likely represent a different type of risk exposure than trading in an index ETF or a different sector ETF before such an event.
The primary takeaway is that traders need to be aware of the different risks they are exposed to when trading an index ETF - as compared to a sector ETF, a niche ETF, or a single-stock.
Depending on your risk profile and existing portfolio, it’s possible that one or more of the products discussed above may fit your strategic approach.
We recommend watching the entire episode of Market Measures focusing on sector ETFs when your schedule allows. If you have any follow-up questions, we also hope you’ll reach out 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.