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Blog Posts — March 13, 2019

New Possibilities in Options-Based Index Strategies

Two recently-launched indices enhance investors’ possibilities in passive options-based strategies. The EURO STOXX 50® Short Strangle Index and the EURO iSTOXX® 50 Collar Index represent two sophisticated and popular strategies among traders and hedge funds. They are constructed on the flagship Eurozone benchmark, the EURO STOXX 50® Index, and seek to generate income and hedge against downside moves. 

Collecting the premium

The EURO STOXX 50 Short Strangle Index was launched on Feb. 20 this year. A short, or ‘sell,’ strangle, involves the simultaneous selling of a put and a call on the same security and with the same expiration date. The index reflects the performance of a strategy that on a monthly basis sells EURO STOXX 50 calls and puts with 5% out-of-the-money strikes, while the index notional is invested at the EONIA rate.

By selling puts and calls, the strategy generates income. The former, in particular, raises what can be a high premium others pay to insure against market losses. At times of increasing implied volatilities, such as witnessed last quarter, the premium, and hence the income generated, rises. The strategy usually results in a low-volatility position, although it can suffer disproportionally with sharp market moves.

Defensive strategy in buying insurance

The EURO iSTOXX 50 Collar Index, on the other hand, aims to replicate a hedging strategy on Eurozone stocks. The index was introduced last October.

A collar is a defensive position that involves purchasing an out-of-the-money put on a stock or index while simultaneously selling an out-of-the-money call on it. The puts offer downside protection and help reduce the volatility of the EURO STOXX 50. 

Writing the call generates income that is used to finance the put. The call caps the upside of the security for the seller – meaning they forgo large gains but can pocket the returns up to the strike price. 

One leg of the strategy consists of purchasing a fraction of two quarterly puts every day, with expiry of 12 months and 15 months, each at a strike price of 90% of the EURO STOXX 50 level. The other leg of the strategy simultaneously sells a fraction of between two and six monthly calls daily, with expiries in the next one and two months. The strategy is additionally long the underlying EURO STOXX 50 Index. The calls are split between contracts with strikes at 102.5% and 104.5% of the underlying’s level. The quantity of options to be bought and sold daily is balanced in order to be, on average, long one put and short one call. 

Each option remains in the portfolio until expiration.

Translating it into returns

The EURO STOXX 50 Short Strangle Index has a five-year Sharpe ratio of 0.78.That compares with a ratio of 0.27 for the EURO STOXX 50, suggesting stronger risk-adjusted returns for the options-based strategy. 

For the EURO iSTOXX 50 Collar Index, which has a shorter history of data, a measure like volatility may be better suited to analyze its performance given its goal of lowering risk. The index shows an annualized volatility of 6.8% in the past three years, while the EURO STOXX 50’s is 14.6%. Since data starts, the maximum drawdown for the collar index has been 12.9%, compared with a 17.5% fall for the EURO STOXX 50.

Access through ETFs

Investing in options is a way for investors to control and exploit volatility, which has become both a critical aspect of portfolio management and an investable asset class in its own right. STOXX manages a comprehensive range of equity volatility and options indices that were recently covered in a research paper.

With these latest indices, investors can tackle two popular derivatives strategies on the liquid Eurozone equity markets with the benefits of a passive approach: rules-based, transparent, systematic and inexpensive. Indices can be packaged into investment products such as exchange-traded funds (ETFs) — opening up, in this case, access to options trades for a large population of retail investors.

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Using total return for the EURO STOXX 50 Short Strangle Index and gross return for the EURO STOXX 50 Index, and based on EONIA.