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

How to trade ETF volatility

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.

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