How the Nations NDX PutWrite Index Measures Risk

When it comes to reducing risk, Nasdaq-100 options are enormously useful for all types of options strategies, including PutWrite strategies. 

The Nations NDX PutWrite Index is designed to sell a sequence of 30-day, just out-of-the-money, Nasdaq-100 Index put options and invest cash in one-month Treasury Bills. The number of put options sold is limited so that the amount of cash can precisely cover the maximum potential loss from the NDX put options.

NDX options, like most index options, can be exercised only at expiration (thus, they are European style) and they are exercised by the payment or receipt of cash representing any loss or gain, since physically delivering a portfolio of the stocks making up the Nasdaq-100 index, in the correct proportion, would be unwieldy. Both exercise and settlement factors make index options perfect for overlay strategies like a PutWrite.

So, how does the Nations NDX PutWrite Index measure risk? 

Like most financial vehicles, it considers a standard deviation of returns, which is how much returns “bounce around,” to be the best measure of risk. Since the inception of our PutWrite Index on Dec. 15, 1994, it has experienced annualized risk (annualized standard deviation of monthly returns) of 14.8 percent while the underlying Nasdaq-100 Index has experienced annualized risk of 24.6 percent. 

The Nations NDX PutWrite does well when the underlying Nasdaq-100 index does well, and relative performance is best when the Nasdaq-100 rallies modestly, but a PutWrite index can also perform well on an absolute basis. In 2009, the Nations NDX PutWrite Index appreciated by 44.8 percent and did so with less than half the risk of the underlying index.

When it comes to reducing risk, a PutWrite index works in part because, over time, we’re likely to sell the put options for more than they will ultimately be worth. However, a PutWrite isn’t a situation wherein we’re trying to dodge a bullet and hope the underlying doesn’t drop in value. While a PutWrite strategy generally does best if the underlying rallies modestly, if the Nasdaq-100 index drops, then we will effectively buy it cheaper next month when the existing put options expire, and we execute a new put option position. Since implied volatility (which is the best “apples-to-apples” measure of an option’s cost) tends to climb when the price of the underlying falls, we are also likely to collect more for the put options we sell next month. 

This increase in the relative value of the put options sold when the underlying falls in value is another type of diversification that drives the superior relative returns of a PutWrite methodology. Investors who use dollar-cost averaging are doing essentially the same thing; they inherently buy more of a stock or index when it is cheap – just when you should be “stocking up” – and less of a stock or index when it is expensive. This phenomenon is automated in a PutWrite index so that the discipline is similarly automated. That is just one reason for the superior risk-adjusted returns of the Nations NDX PutWrite Index.

The Nations NDX PutWrite Index closed at 959.88 on Wednesday, Oct. 16, 2019. That’s up 13.70 percent for the year and just 0.20 percent below the all-time high.

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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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