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500 BuyWrite Index (BXM)—was announced in 2002. The BXM Index assumes that slightly out-of-the-money S&P 500 options are written on the third Friday of every month, and the average gross monthly yield for the BXM Index (using the premium received as a percentage of the underlying) has been about 1.8 percent. Figure 12 shows the rolling 12-month gross premiums for the BXM Index, and the rolling 12-month net returns for both the BXM Index and S&P 500 Index. In Figure 12, note that the BXM net return has been pretty close to the BXM gross premiums in times of steadily rising stock markets. However, in years in which the S&P 500 has experienced big drops (e.g., 2001 and 2008), the BXM net return was generally above that of the S&P 500, and far below the BXM gross premiums as a percentage of the underlying. Managing Of Left-Tail Risk And ‘Black Swan’ Events After witnessing two big declines in stock index values since the year 2000 (see Figure 2), many investors in recent years have heightened concerns about left-tail risk and catastrophic “Black Swan” events that could harm Figure 11 Diference in Volatility Points Figure 12 80% 60% 40% 20% 0% -20% -40% 10 5 0 -5 -10 Implied Volatility (VIX) Minus Subsequent SPX Realized Volatility (SPX Options Usually Have Been Richly Priced) -15 6/90 6/93 6/96 6/99 6/02 6/05 6/08 6/11 (June 8, 1990 - July 20, 2012) Rolling 6-month average of the spread between end-of-week VIX and the subsequent 30-day SPX realized volatility Sources: Bloomberg and CBOE Rolling 12-Month Gross Premiums And Net Returns -60% 6/89 6/92 6/95 6/98 6/01 6/04 6/07 6/10 BXM Gross Premiums ■ BXM Net Return ■ S&P 500 Net Return (June 1989 – July 2012) Sources: Bloomberg and CBOE Note: BXM gross premiums are received every month and are expressed as annualized % of the underlying S&P 500 Index. Net returns are for total return indexes. Figure 13 160 120 80 40 0 -24% to -20% Tail Risk And Frequency Of Monthly Returns (July 1986 - July 2012) 40 2624 10 11 1 0 1 0 1 0 1 2 1 0 -20% to -16% -16% to -12% -12% to -8% ■ S&P 500 -8% to -4% 105 -4% to 0% 140 127 0% to 4% ■ CLL Index (collar) 4% to 8% 8% to 12% 12% to 16% During the 26-year time period, the S&P 500 Index had 13 months with returns worse than -8%, while the CLL Index had only one such month. Sources: Bloomberg and CBOE their investment portfolios. An options strategy that could be explored by risk-averse investors is the “collar” strategy, in which one purchases stock, buys protective put options for downside protection and sells covered calls for income that can help pay for the put premiums. A key benchmark for the collar strategy is the CBOE S&P 500 95-110 Collar Index (CLL), which buys S&P 500 puts for downside protection, and sells S&P 500 calls for income. Note that in Figure 13, the CLL Index was able to lessen much of the left-tail risk. During the 26-year time period, the S&P 500 Index had 13 months with returns worse than -8 percent, while the CLL Index had only one month with a return worse than -8 percent. Correlations And Diversification Over the past decade, many investors have become more concerned about challenges to diversification, as there have been increasingly higher correlations among “traditional” investments. As shown earlier in this paper, in Figure 4, the correlations of weekly returns versus the S&P 500 for various indexes were: • 0.96 for the Russell 2000 • 0.88 for the MSCI EAFE • -0.84 for the CBOE VIX Index Figure 14 shows correlations among various indexes. The BXM, BXY, PUT and CLL all hold the S&P 500 stock basket, and so it is not surprising that all four of those indexes had correlations of 0.89 or higher versus the S&P 500 Index during the time period. The BXY Index writes out-of-the money (OTM) S&P 500 options, and so it can rise and fall with the S&P 500 Index (up to 2 percent up during the monthly time period). Not surprisingly, the correlation of the BXY and S&P 500 was 0.95. The CBOE S&P 500 95-110 Collar Index (CLL) buys S&P 500 protective puts for protection. Even though the CLL Index and S&P 500 Index had a 0.89 correlation in Figure 14, there also is evidence (in Figure 13) to suggest that the CLL Index can help provide some protection when the stock markets suffer big drawdowns. 74 60 www.journalofindexes.com November / December 2012 25
• -0.70 for the S&P 500 VIX Mid-term Futures Index (SPVIXMTR) • -0.63 for the S&P 500 Dynamic VIX Futures Index (SPDVIXT) • -0.60 for the S&P 500 VIX Futures Tail Risk Index – Short Term (SPVXTRST) Some investors who are exploring the possibility of using index options have asked the question, Do the index options markets have the capacity and liquidity to handle large influxes of new institutional funds that will be dedicated to options-based strategies? While the negative correlation of the VIX to many traditional investments can make the VIX appear to be attractive, the VIX is an index that is considered not investable. Exhibit K of a paper by Asset Consulting Group, “Key Tools for Hedging and Tail Risk Management” (February 2012) showed the correlations of weekly returns of various indexes in the period from April 7, 2006 through Feb. 3, 2012. Listed below are the negative correlations versus the S&P 500 Index for three indexes that use VIX futures and are designed to reflect approximate investable performance (however, no index is considered 100 percent investable with no tracking error or transaction costs). 9 Figure 14 Figure 15 Notional value, in $millions S&P 500 1.00 Sources: Bloomberg and CBOE Notional Value Of Average Daily S&P 500 (SPX) Options Volume, With 0.5 Delta Adjustment $80,000 $60,000 $40,000 $20,000 Correlations Of Weekly Returns (June 30, 2006 – August 24, 2012) BXM 0.92 1.00 S&P 500 BXM BXY PUT CLL VIX S&P 500 VIX Mid-Term Futures Index BXY 0.95 0.99 1.00 PUT 0.90 0.98 0.97 1.00 CLL 0.89 0.73 0.81 0.71 1.00 VIX -0.72 -0.67 -0.71 -0.66 -0.69 1.00 S&P 500 VIX Mid-Term -0.70 -0.62 -0.66 -0.63 -0.67 0.74 1.00 Futures Index $0 1/01 1/03 1/05 1/07 1/09 1/11 Source: CBOE (unofficial estimates) Note: The notional volume estimate for June 2012 was $51 billion, and was calculated by multiplying four numbers: 750,652 (avg. daily contract volume); 1362.16 (S&P 500 end-of-month value); $100 (options multiplier); and 0.5 Capacity And Liquidity Some investors who are exploring the possibility of using index options have asked the question, Do the index options markets have the capacity and liquidity to handle large influxes of new institutional funds that will be dedicated to options-based strategies? The listed options markets now offer options on thousands of securities, and the liquidity and capacity of options markets on different securities can vary significantly. The market for options on the S&P 500 Index is the largest listed options market in the U.S. in terms of notional size. Figure 15 provides estimates for the notional value of the average daily SPX options volume, and it uses a 0.5 delta adjustment to make the figure more conservative and realistic as compared with notional value statistics that do not use any delta adjustment. The delta-adjusted notional volume estimate for the average daily volume in June 2012 was about $51 billion. The liquidity and flexibility offered by S&P 500 stocks and S&P 500 options usually have compared favorably compared with investments such as private equity. Investors should do their own due diligence and discuss with their brokers issues regarding capacity and liquidity for any security. Conclusion Since 1983, index options have been used by institutional and individual investors for a variety of purposes, including managing risk and generating income with the goal of boosting risk-adjusted returns. Since 2002, investors have had options-based benchmark indexes with which to measure the advantages and disadvantages of key options-based strategies in bullish and bearish markets. This paper highlights some of the key features of the discussed indexes: Total Growth. Total growth for the following indexes from June 30, 1986 through July 31, 2012 was 1,240 percent (10.46 percent annualized) for the PUT Index, 886 percent (9.2 percent annualized) for the BXM Index, 903 percent (9.2 percent annualized) for S&P 500 Index, and 390 percent (6.3 percent annualized) for the CLL Index (Figure 6). Lower Volatility. The PUT, BXM and CLL indexes all had 26 November / December 2012
Page 1 and 2: Plus Blitzer on the history of opti
Page 3: Contributors Mark Abssy Mark Abssy
Page 6 and 7: STOXX LIMITED INNOVATIVE INDEXING.
Page 8 and 9: People’s futures are in your hand
Page 10 and 11: ©2012 Morningstar, Inc. All rights
Page 12 and 13: Exchange-traded products span a wid
Page 14 and 15: Figure 5 Median notional Volume ($B
Page 16 and 17: the put spread in this example is $
Page 18 and 19: The Loch Ness Monster. Sightings of
Page 20 and 21: TAKE A NEW LINE WITH YOUR EQUITY Po
Page 22 and 23: Over the past 12 years, U.S. invest
Page 24 and 25: Figure 6 $15 $12 $9 $6 $3 5 Indexes
Page 28 and 29: volatility that was about 30 percen
Page 30 and 31: Most investors are familiar with op
Page 32 and 33: equired to establish this position
Page 34 and 35: THE POWERSHARES DB COMMODITY INDEX
Page 36 and 37: Depression was history, rather than
Page 38 and 39: academic assessment of the very exi
Page 40 and 41: Alternative Investments 4.0% Real E
Page 42 and 43: tion and management. Within it, an
Page 44 and 45: Much ink has been spilled on the pe
Page 46 and 47: Figure 1 sectors No. of top dogs Re
Page 48 and 49: over the 30-year span. “Business
Page 50 and 51: States, the average concentration p
Page 52 and 53: Figure 10 sectors Source: Research
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Page 58 and 59: open the Etracs Long-Short S&P 500
Page 60 and 61: Morningstar Index Funds U.S. Style
Page 62 and 63: Exchange-Traded Dow Jones U.S. Indu
Page 64 and 65: ETF Analytics Your clients want mor
Page 66 and 67: PICK THE HIGH HANGING FRUIT. Find 1
Page 68 and 69: InsideETFs portFolio management str
Page 70 and 71: ©2012, THE NASDAQ OMX GROUP, INC.
Page 72: Crossword Thinking About Options Te

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