Download complete issue - IndexUniverse.com

The following steps are taken to select spread pair components
for each index:
i) Establish total population of available SPY option contracts
for the front and second month.
ii) Refine selection universe based on eligibility/liquidity
requirements.
iii) Create all possible ATM vertical spread pairs.
iv) Create and equal-weight overall rank for each pair by
calculating and ranking on various criteria based on factors
such as strike spread and net credit.
v) Based on the sold leg of each spread, determine the
distance away from ATM (money-ness).
vi) Allocate spread pairs along proprietary money-ness
and expiration criteria.
vii) Apply an equal weighting to all spread pairs.
Index components are evaluated using bid/ask pricing.
Midpoint pricing is used for the real-time and end-of-day
index level calculation. The index is rebalanced monthly in
conjunction with the regular options expiration calendar.
To manage downside volatility, each index employs
loss floors at the individual spread level. Once a spread
pair has priced through the floor on an end-of-day basis,
the component’s weight in the index is allocated away
from the spread pair and moved to a cash proxy until the
next rebalance cycle. While this approach is effective in
managing downside risk over a few days or in between
rebalance cycles, it is ineffective in controlling any oneday
market event. Managing downside risk in this manner
not only limits losses but mitigates the risk of any positions
being assigned and forcing the delivery of shares of
the underlying for any investor following the index.
Figure 5 shows this loss floor in action. This graph
highlights the complete options cycle for December 2011
(11/18/2011 to 12/16/2011). In the December period,
SPY trades off early in the cycle and we see the bullish
index trading off as well. What is hidden is the loss-floor
mechanism. Figure 6 provides an analysis of index components
during this period.
The loss-floor mechanism allows for those positions
that could cause more drag on performance to be allocated
to cash, and without significant lag. It sometimes
is the case with sharp moves in SPY that the entire index
spends some time during the expiration cycle allocated
completely to the cash proxy, but as mentioned earlier,
the cash proxy weight is reallocated to new spread pairs
in the next rebalance cycle. The example given represents
one period and is unique, meaning it will not
always be the case that a -2.21 percent move in SPY will
result in 27 spread pairs being reallocated to the cash
proxy, or more generically, that an aggregate move of X
percent in the underlying will always result in a particular
action occurring in the index.
Unlike other options strategy indexes, these indexes
solely include options contracts and do not contain any
underlying security as a component. In designing these
indexes, we realized that investors looking for optionoverlay
products wanted just that—an option overlay. It
did not make sense to force investors to double-up on
Figure 7
Figure 8
Dates
Source: Bloomberg
Performance Comparison
SPY
(Equity)
VCS
(Index)
VPS
(Index)
01/21/2005 – 12/31/2005 8.50% -30.93% 32.30%
12/31/2005 – 12/31/2006 15.85% -43.93% 55.95%
12/31/2006 – 12/31/2007 5.14% 62.80% -35.15%
12/31/2007 – 12/31/2008 -36.81% 225.41% -12.77%
12/31/2008 – 12/31/2009 26.37% 1.26% 19.62%
12/31/2009 – 12/31/2010 15.06% -60.81% 53.78%
12/31/2010 – 12/31/2011 1.89% -52.49% 16.50%
12/31/2011 – 8/31/2012 13.54% -43.76% 38.57%
Source: Bloomberg
Historical Index Performance, January 2005-August 2012
450
400
350
300
250
200
150
100
50
0
1/21/05 1/21/06 1/21/07 1/21/08 1/21/09 1/21/10 1/21/11 1/21/12
■ VCS Index ■ VPS Index ■ SPY US Equity
the existing underlying stock positions or have to incur
transaction costs or create taxable events in order to get
exposure to these strategies.
Figure 7 shows some periodic returns of each of the
indexes as compared with the underlying (SPY) for
each calendar year since the indexes’ inception. Figure
8 shows the historical trend lines for the indexes versus
SPY. While the indexes’ base dates are both Jan.
21, 2005, the indexes commenced operation on Sept.
16, 2011, and all prior index levels are backtested. As
component selection for these indexes is a purely quantitative
process, there should be no concerns regarding
survivorship bias or other forms of “cherry-picking”
that could influence any backtested results. The base
date of Jan. 21, 2005 was chosen as it was the date that
ISE and the other U.S. options exchanges first listed
options contracts on SPY.
The development of the VCS and VPS indexes began as
an academic exercise, but they have real-world potential
to help investors gain exposure to options in a sophisticated—yet
straightforward—approach. Composed of option
contracts that are centrally cleared, exchange listed, continuously
quoted and among the most liquid and heavily
traded contracts in the marketplace, the indexes could
provide investors access to a truly unique and useful way
to express their opinions on the market.
32
November / December 2012