Implied Volatility Dynamics Among Exchange-Traded Funds and Their Largest Component Stocks

This article examines the presence of common factors in the evolution of stock option implied volatilities. We analyze the implied volatilities of ETF options and their largest component stocks, and the results strongly suggest the presence of both a market volatility factor and an industry volatility factor. In a cross-section of nine popular industry ETFs, the average volatility “betas” for the industry factors are equal to about one third of the value of the market factor beta. Additionally, implied volatility reverts more strongly to industry long-term averages than it does to a market measure of volatility. Traders, market-makers, and investors may reduce hedging errors by using options on these industry-related products in addition to market-based volatilityproducts. The drivers of implied volatility spillovers from ETFs to component stocks vary across industries, but the spillovers are most strongly related to turnover in S&P 500 ETF options and those of SPDR industry sector ETFs. Additional important factors in the volatility generating process include deviations from net asset value, ETF flow of funds, and ETF market capitalization