Components of the Nations NDX PutWrite Index and the Importance of Time Value

Earlier this week we introduced the Nations® NDX PutWrite index.  The goal of the index is to capture most of the returns of the underlying Nasdaq-100 index, ticker symbol NDX, with substantially less risk by systemically selling options on the Nasdaq-100 index and segregating the cash to cover any potential loss, even if the index drops to zero.  Since we’ve set aside the cash this strategy is sometimes called a cash-secured put. 

As we detailed earlier, one reason our PutWrite strategy can generate superior risk-adjusted returns is because, over time, we’re likely to sell the options for more than they are ultimately worth.  Options are like insurance and after paying claims and wages and overhead insurers usually have money leftover which is profit.  Option pricing is similar.

So how does the index actually work and what is in the PutWrite portfolio?

The first thing is cash.  If we were to buy the stocks making up the Nasdaq-100 index we would start with cash; the same is true for our PutWrite index.  In the case of the Nations NDX PutWrite that cash is in an interest bearing account and we assume it’s earning the 30-day Treasury bill rate.  The second element is a short position in an NDX put option expiring on the third Friday of the month.  The third Friday of the month is the traditional expiration date for monthly options so while there are a number of expiration dates available for NDX options the options expiring on the third Friday work for our PutWrite.  Once our put options have expired on that third Friday we’ll sell new put options expiring on the third Friday of the next month.

How do we select the strike price of the NDX option to sell for our PutWrite?  NDX and NQX options offer a wide range of strike prices in each expiration.  Since the options which are closest to at-the-money, meaning their strike price is closest to the current level of the Nasdaq-100 index, have the most time value we’ll sell the first strike price which is out-of-the-money.  This means we’ll sell the option with the first strike price below the current index level.  The Nasdaq-100 closed at 7690.53 on October 9.  Of the options expiring on the third Friday of the month, October 18, the first strike price below 7690 would be the 7680 strike price.  That would be the option we would sell if we were implementing the PutWrite strategy at the close of trading on October 9.  We’ll discuss how many of these options to sell in another post.

These are the simple building blocks for constructing a PutWrite strategy.  As time has shown, the Nations NDX PutWrite generates good returns albeit returns which are slightly lower than the underlying Nasdaq-100 index but does so with substantially lower risk.

Let’s circle back and discuss one of the primary building blocks for our PutWrite index.  The put option sold has a strike price just below at-the-money meaning we sell the put option with a strike price just below the current level of the Nasdaq-100 index.  We sell that option because it has the most “time value.”  What do we mean by time value for these NDX options?

The value of an option is generated by the ability of the owner of the option to wait and see if they want to act; to buy in the case of a call option or sell in the case of a put option.  They are essentially buying time so this freedom to wait is called “time value.”  Time value erodes as time passes as you would expect. 

The likelihood of a deep out-of-the-money option being in-the-money at expiration is remote so a deep out-of-the-money option has little time value; there’s not much point in paying money just to wait and see if something really unlikely will come to pass.  The likelihood of a deep in-the-money option being in-the-money at expiration is extremely high.  Once again, there’s not much time value.  But the likelihood of an at-the-money option being in-the-money at expiration is 50/50.  So an at-the-money option (or the just out-of-the-money put option we’re selling in our PutWrite index) has lots of time value.  This is what we’re collecting when we sell an option so we want to collect as much of it as possible.

This understanding of time value can help guide you to more successful option trades beyond our PutWrite index.  We’ll continue this discussion of time value and how it impacts the returns and risk of our PutWrite index in a future post.

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Scott Nations

Scott Nations is the President of Nations Indexes and a bestselling author. Scott is also a Contributor to CNBC and regularly appears on-air to discuss markets, current economic events, and the outlook for a variety of financial vehicles. Nations Indexes is the world’s leading independent developer of volatility and option enhanced indexes and investment vehicles.

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