Derivatives: Markets, Valuation, and Risk Management

CHAPTER 15

Stock Index Products: Strategy Based

Many stock index products are inextricably linked to particular index derivative trading strategies. This chapter focuses on such products. The first is portfolio insurance. Portfolio insurance is a means of protecting a stock portfolio against the prospect of declining prices. Like any insurance policy, the face amount of the insurance is prespecified as is the life of the policy. The insurance is purchased by buying a put, either directly or synthetically, with an exercise price equal to the face amount of the insurance and a time to expiration equal to the term of the policy. Buying the put directly is called passive portfolio insurance; creating it synthetically, dynamic portfolio insurance. The first section describes a variety of portfolio insurance trading strategies.

The second group of products are funds based on an index/option trading strategy. The first such product to appear in the marketplace was based on the CBOE's Buy-Write Index (BXM). The BXM buy-write strategy involves buying the S&P 500 index portfolio and selling one-month, at-the-money call options. While such a strategy should theoretically perform the same as the S&P 500 portfolio on a risk-adjusted basis (as we demonstrated in Chapter 10), it has performed better over the last 16 years. The reason is that index options appear to have been overpriced (i.e., their implied volatility has been too high relative to realized volatility) and converge to their correct ...