June 26, 2007
This month, the Chicago Board Options Exchange (CBOE) launched what could be considered a companion index to its popular CBOE S&P 500 BuyWrite Index, otherwise known as the BXM. The new CBOE PutWrite S&P 500 Index (PUT) tracks the performance of a put-selling options strategy applied to the S&P 500, in much the same way BXM tracks the performance of a covered call options strategy applied to the same index.
BXM has been incredibly successful for the CBOE. Dozens of closed-end funds, structured products and even one exchange-traded note (ETN) have been launched using various buywrite strategies, largely because of interest stirred up by the BXM. CBOE hopes that PUT will prove similarly popular.
The two indexes, however, are very different animals.
The BXM is a covered call index. It tracks a portfolio that sells call options on the S&P 500 against a long portfolio of the component stocks of the S&P 500. The index has been hugely popular with investors, who have used it as a way to generate low volatility returns.
PUT flips the BXM strategy on its head. Instead of writing covered calls, PUT sells one-month, at-the-money S&P 500 put options against collateralized cash reserves held in a money market account.
A put is an agreement to buy a security at a given price at some point in the future. In exchange for a premium, the put seller commits to buy a given stock for $X/share at such-and-such a date. Nervous long investors buy puts to protect themselves from downside risk: if the stock trades down before the put date, they know that they can still sell it for the named price (if it trades up, however, they aren’t required to sell it to the put holder). Meanwhile, the put seller makes money from the premiums, and hopes that the underlying stocks don’t crash in the meantime.
In the PUT index, the number of puts sold is constrained by the amount of cash reserves needed to cover a total loss at settlement of the S&P 500 puts—meaning that the strategy is designed to ensure that an investor does not lose any more than his or her total investment.
The PUT index has a slightly different performance profile from the BXM, which has historically performed well in negative to gradually rising markets. The PUT, however, does well in a flat or declining markets, and has displayed its best performance in highly volatile markets. That suggests that the strategy could be a useful hedging tool, an intriguing possibility in an era when investors of all stripes are striking out into new territories looking for diversification.
The PUT index is notable in that from 1988 to 2007 it exhibited higher returns and lower volatility than both the S&P 500 and the BXM. According to a report issued by the CBOE, the PUT returned 12.65% on an annualized monthly basis for the period covering June 1988 to May 2007. Meanwhile, the S&P 500 Total Return Index returned 11.86% and the BXM 11.86%. The report also notes that the PUT monthly returns tend to rise with the S&P 500, although less dramatically, and that the PUT’s returns are usually greater than those of the S&P 500 and BXM when the S&P 500 turns negative (or small/flat).
“The leverage of the PUT is greater than the leverage of the BXM, and the PUT therefore yields a different rate of return,” the report states.
Matt Moran, vice president of business development at the CBOE, says that the CBOE originally developed the BXM index—the first major options benchmark— with an eye to attracting institutional investors to the options market. Firms like Morgan Stanley liked the strategy enough, however, that they used it as the basis for structured products that have, in turn, attracted individual investors.
“It does build on the BXM,” Moran says of the development of the PUT.
There are four strategies associated with options—long call, short call, long put, short put—so there were other paths the CBOE could have followed when it chose to develop a new index, but the PUT was perhaps the more logical result.
“Short options strategies generally had better risk-adjusted returns than comparable long strategies,” Moran says.
The CBOE has other indexes in its BuyWrite family, including ones based on the Dow Jones Industrial Average and the Nasdaq-100. However, it has not yet announced any plans to launch any additional PutWrite indexes.
Although Moran says the CBOE has seen interest from a variety of sources regarding the development of products based on its newest index, he also emphasizes that investable products are not the only important result of the introduction of any of these indexes—they are important as indicators of market performance as well.
About ten years ago, before the BXM existed, an investor looking to discuss the results of a covered call strategy would have gotten a largely anecdotal response, Moran explains. Now that type of strategy has a benchmark that can be used as a standard to measure performance.
Moreover, the indexes are helping to change the perception of options, which had often seemed too risky to investors who viewed themselves as conservative, he adds. “But the volatility [of the indexes] is actually lower.”