Articles

Creating A Vertical Spread Index
By Mark Abssy

Related ETFs: SPY

Page 6 of 8

The ISE Options Overlay indexes provide benchmarks for investors looking to track the performance of a diversified portfolio of exchange-listed options utilizing the vertical spread strategy. As indicated by the name, each index solely includes option contracts on the SPDR S&P 500 exchange-traded fund (NYSE Arca: SPY).

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 one-day 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.