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February 24, 2006

Buying a Young Index: A New Wrinkle on Familiar Strategy

By Mark Longo

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  • Buying a Young Index: A New Wrinkle on Familiar Strategy
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The options industry continues to set new trading records every year. Unfortunately, despite this explosion in volume, investors remain skeptical of the options markets. For these skeptics, the notion of using options in conjunction with their equity portfolios remains a daunting prospect. The options industry has spent millions of dollars developing proprietary productsto lure reticent equity traders into the fold.

But few of these products have managed to withstand the test of time. Some of them simply vanished into obscurity. Others failed to garner enough volume to merit serious attention. Once in a great while, however, a product comes along that is inventive enough to survive the perilous options world.


One such product is the CBOE's BuyWrite Index (BXM). The BuyWrite product line has slowly managed to carve out a niche in the options world.

The BuyWrite Index faced a number of hurdles when it was launched, not the least of which was its name. Although BuyWrite is a common term among options traders, few outside the industry have ever heard of it. Instead, they refer to the strategy of buying an underlying security and writing a call against it as a "covered call."

When the BuyWrite Index was created in 2001, covered calls had a bad reputation in the equity world. Many equity traders still had nightmarish memories from the late 1990's. That's when their covered call strategies badly underperformed the rampaging bull market. As a result, the CBOE had to cloak its covered call index with the archaic name BuyWrite Index just to give it a fighting chance with its target market.

Although the name BuyWrite Index remains a mystery to many investors, the underlying mechanics of the product are quite simple. The BXM replicates the return of owning the underlying S&P 500 index and writing calls against it.

"The strategy is essentially selling the front month at-the-money calls," says CBOE Vice-Chairman Ed Tilly. "For the purposes of the BXM, it would be owning the S&P 500 index and selling the front month at-the-money calls in the SPX."

While many hedge funds and portfolio managers write calls against their stocks, they usually only do so about once a quarter or once a year. However, the BXM writes calls against the S&P 500 every month. This increased frequency was chosen for two reasons. The first reason is to capture the higher level of time decay that comes from writing short-term options as opposed to longer-term options.

"Most people who write calls against their portfolios choose to write longer dated, out-of-the-money-options. But we decided to go with one month at-the-money, or slightly out of the money, calls," says Matt Moran, Vice-President of Business Development for the CBOE. "The reason is that, if you write twelve 1-month options, then you should collect nearly twice as much time decay as if you wrote four three-month options."