Theoretically, there is less risk in trading options on indexes versus trading single stocks due to the specific risk that a single stock holds. The recent tasty BITES from June 1, 2016, "Uncorrelated Trading" reminded us of the importance of correlation and diversification in our underlyings. Keeping that in mind when it is best to trade the indices and when it is best to trade individual stocks? Is there any tool we can use that would help us?
The CBOE offers an Implied Correlation Index (JCJ) that shows the current correlation of option prices on SPX to that of its top 50 holdings. A high JCJ reading translates to high correlation between option premium on SPX and option premium on its stocks. We know that during market selloffs Implied Volatility (IV) increases and the correlation between stocks increase. The greater the selloff the more IV increases and the greater the correlation will be between individual stocks. Since there is little advantage in lower correlation and the individual stock risk still exists it is better to trade the indices during such environments.
A different market environment, such as the current complacent market which sees the Implied Correlation Index (JCJ) trading at its lows for the last year, is an opportune time to seek higher IV in single stocks for short premium trades. There are still earnings announcements that mean higher IV opportunities
For more information on the Indices see:
The Skinny On Options Data Science from April 7, 2016: "Part 1: What Affects the Indices"
The Skinny On Options Data Science from April 21, 2016: "Part 2: What Affects the Indices"
Market Measures from May 13, 2016: "U.S. Indices: Actual Moves vs Expected Moves"
Watch this segment of Options Jive with Tom Sosnoff and Tony Battista for the important takeaways and to learn about the JCJ and how we can use it to determine when we should trade the different stock index options or the individual stock options.
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