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Options on ETFs vs Their Holdings

Best Practices

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

Our studies have consistently shown that selling option premium in high Implied Volatility (IV) and high IV Rank (IVR) underlyings outperforms selling in low IV and low IVR underlyings. We’ve observed that an index ETF will have a lower IV than its individual stock components. Is it accurate that ETFs have a lower IV than the individual stocks that comprise it and does this mean that we should be trading options on the individual stocks instead?

A graph plotted the XLF (Financial ETF) and XLU (Utilities ETF) along with some of their component stocks for IVR by IV. We prefer underlyings that are in the top right of the graph which means high IV and IVR. Both ETFs were in the lower left area while their individual stocks were in a more favorable area. A separate graph of the distribution curves of their Standard Deviation moves demonstrated that individual stocks have had more outlier moves than ETFs over the last several years. ETFs are less vulnerable to large moves driven by news, earnings and events due to their diversification.

A table comparing average bid/ask spreads of the at-the-money (ATM) options in the XLF & XLU and 3 of their top holdings was displayed. The table showed that the ETFs tend to have better liquidity than their holdings. We believe in the importance of liquidity so much that we have a liquidity indicator on the dough platform. The edge from higher volatility can quickly disappear due to lower liquidity.

For more information on Trading ETFs see:

Watch this segment of Best Practices with Tom Sosnoff and Tony Battista for the important takeaways and a better understanding of the advantages and drawbacks between trading the options of the individual components of an ETF versus the options on the ETF itself.

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