Since the first option on an exchange-traded fund (ETF) was launched on the American Stock Exchange in 1998, followed by the Chicago Board Options Exchange in 2000, the market segment has grown steadily in popularity.
Investors now benefit from a wide range of ETF underlyings, from U.S. equity indexes to all kinds of stock-, bond- and commodity-based ETFs. However, quite a few ETF options still exhibit low trading volume. Many ETFs are quite specialized and, therefore, cover specific market segments that interest only a few investors.
In contrast to more popular options in broad-based equity indexes, these ETF options also are American style; they are physically settled and are subject to early exercise. A proper understanding of the products combined with an analysis of correlation, skew and volatility levels — both implied and realized — uncover opportunities that can supplement any trading plan.
Assessing opportunity
There are many liquid ETF and index options that give investors numerous investment choices. To get a feeling for the option underlyings, “Correlation matrix” (below) lists correlation values for some selected ETFs and equity indexes based on three-month implied volatilities and spot price changes (reported in dollars) based on weekly data for the last three years.
Obviously, the implied volatilities and spot correlation tables look alike because of the relationship between volatility and spot movements. Although those correlations are not stable over time and appear high for this sample, the figures indicate opportunities for investors to diversify their portfolios. Especially interesting is how correlations between commodity-based ETFs and those based on emerging markets are, on average, lower than their correlations with U.S. and European equities.
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.
Another way to reduce the risk of a short put exposure is a put ratio spread. Investors can profit from a positive skew by adding at-the-money put options on the same underlying to the existing short out-of-the-money option position. The analysis in this case turns from one implied volatility number to the pair of at- vs. out-of-the-money volatilities (see “Skew analysis”).
The ratio of long at-the-money options vs. short out-of-the-money options can be adjusted to obtain a premium-neutral or delta-hedged position. In those cases, the number of puts to be shorted is, of course, higher than the long at-the-money put position, as both the premium and the delta are lower for out-of-the-money options.
Taking trades
The following trades illustrate a put-ratio spread on the S&P 500 that, at the time of the trade, exhibits a high skew. Set up as a premium-neutral trade with three months until expiration, the resulting position has a slightly positive delta at initiation. The example is based on a current spot price of 1400 for the S&P 500.
- Buy 100 put contracts with strike 1400 and expiry in three months.
- Sell 280 put contracts with strike 1275 and expiry in three months.
As the black line in “Valuing the trade” (below) indicates, the profit and loss at expiration would be flat for prices above 1400 and would increase for falling spot prices until 1275 where the short puts expire worthless. Losses would be expected for prices around 1205 and lower.
For those investors who believe that the skew is not high enough, the reverse position in the form of short at-the-money options and long out-of-the-money options is an alternative. Because the out-of-the-money options would outnumber the at-the-money options, the position gains if we see a huge downturn in the market.
An analysis of a long put spread before maturity is important for understanding the trade. If the position is set up with a low positive delta and theta at initiation, the trade profits from a positive performance of the S&P 500 and time decay. The “Greeks,” however, change during the term of the trade. For example, closer to expiration, the delta can turn negative (positive) if the spot stays above (far below) 1275. The theta, although usually positive, can turn negative for high S&P 500 values close to expiration. That’s because at initiation the investor doesn’t want the S&P 500 to drop too quickly, which would result in trade losses. On the other hand, getting closer to maturity, the spot should move to where the trade becomes most profitable, which in this example would be 1275.
Note that this position is not a pure skew position. Like the changes in the Greeks, the spot movements lead to movements on the volatility surface. The trade does not necessarily profit directly from a change of it. That is, if the spot moves from 1400 to 1275, the at-the-money and out-of-the-money options change into in-the-money and at-the-money options. Without any adjustments, the skew analysis is no longer properly applicable.
Still, because of the long and short positioning in those options, a high skew at initiation is beneficial: The higher the skew, the lower the number of out-of-the-money put options necessary to reach a delta- or premium-neutral position at initiation.
Marco Erling is a portfolio manager and quantitative analyst for structured products with HSBC Global Asset Management. He studied mathematics at the University of Dortmund in Germany and earned an MBA from ESADE Business School in Barcelona. He is a CFA Charter holder and a Certified FRM holder. Email him at marco.erling@hsbc.de.
