From the December/January 2013 issue of Futures Magazine • Subscribe!

How to trade ETF volatility

In “Volatility view” (below), we list some average at-the-money volatility, implied-to-realized spreads and skew figures for some ETFs and equity indexes. Although the three years between March 2009 and November 2012 represent only a short time period, the numbers display some general trends that are observable for longer time series and in other markets, as well: Most notably, on average positive implied-to-realized volatility spreads and high skew levels for equity indexes or equity ETFs.

The positive implied-to-realized spread is a supporting argument for short volatility investments such as, for example, selling short-dated out-of-the-money put options. Because these positions contain delta-positive exposure, they are intended for those investors who expect a neutral to positive performance of the ETF underlying.

With a spot price of around $42 for the iShares Emerging Markets Index, selling a one-month put option with a strike of $38 currently would generate income of around 30¢. However, people should be aware of the downside risks if markets crash. One way to reduce this risk is to take the premium and purchase a put option on an underlying that is positively correlated to the iShares ETF.

Investors with a more positive view on emerging markets compared to the S&P 500 — and who identify S&P 500 volatility as cheap compared to emerging market ETF volatility — may want to take the iShares Emerging Market ETF put premium and buy S&P 500 put options. With a high skew on the S&P 500, investors should select put options that are closer to at-the-money. In this case, the number of long S&P 500 put options should be adjusted to reflect the higher delta of at-the-money options.

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