Should Market-Neutral Options Traders Diversify?

We generally restrict iron condor trades in our paid newsletter and managed accounts to index products. For those who prefer ETFs, we look at SPY, DIA, IWM, QQQQ; otherwise, SPX, RUT, NDX, DJX are bigger proxies, or on the futures side of things we’ll look at the Emini S&P 500 or Nasdaq 100 (ES and NQ). The reason we trade index products is that diversification reduces the impact of company-level surprises: an iron condor on, say, RIMM will get punished if someone discovers that Blackberries cause some disease (in addition, that is, to destroying users’ basic social skills), while a condor on some Nasdaq 100 product won’t be affected in the same way.

That’s a good argument for trading condors on indexes rather than individual stocks, but what about the vast territory in between? Member DA raises the question this way:

I know you only trade iron condors on the SPY ETF; can you suggest another ETF that doesn’t have a strong correlation with the S&P500 for one to trade iron condors on in conjuction with the SPY. I think DIA, MNX, IWM all seem to be strongly correlated, but what do you think of XLE or FXI?

In other words, what about sector or country ETFs (or other products) that offer the same or similar levels of diversification, but are also not so correlated to the U.S. market? The thought here is that a bad month for an SPY position might be a good month for an XLE trade.

I see the attraction of this approach, but I’m not sure how helpful it would be in the long run. If you’re the sort of trader who sells options or option spreads on a consistent basis, I think you’ll find that adding foreign or sector-based products to your regime may yield disappointing results. Here are some betas for popular ETFs (source: thinkorswim):

Product Beta
FXI 1.9
EEM 1.5
EFA 1.19
XLE 0.81
XLI 1.19
XLF 1.55
USO 0.4
GLD 0.53

If your goal is to trade some products that zig when the market zags – or that simply do their own thing – many foreign and sector-based products won’t fit the bill. I included some commodities at the end of the table to suggest that, for real diversification with reduced correlation, non-equity assets deserve a look.

There’s another, more important reason why I don’t trade non-index products in the newsletter. Unlike many traders who rely on technical analysis or fundamentals to generate trade ideas, I don’t enter positions based on chart patterns or P/E ratios. Instead, the strategy followed in the newsletter is designed to collect the volatility risk premium in U.S. equity index options. It is entirely possible that a similar premium exists in other markets or even in other asset classes, but we would only trade options on those assets in the newsletter given sufficient evidence of a such a premium.

Of course, if you’re a fan of technical, fundamental, or some other school of analysis, it bears noting that any option spread is in principle applicable to any underlying asset, given the right conditions. The classic example in the case of iron condors is of a technical prognosticator who believes, for whatever reason, that an asset is likely to trade within a range over some period of time. If your thesis is correct, it hardly matters whether the asset under consideration is a highly liquid sector product or a Burkina Faso ETF.

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Jared Woodard specializes in trading volatility as an asset class. With over a decade of experience trading options and other volatility products ... Read More

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