Question: Is there a strategy to take a directional position in an equity index with minimial risk?
Answer: A well-constructed SPX/OEX (1-5) options spread.
A strategy little known to all but the most sophisticated trade is something called 1-5. This strategy is a play between the S&P 100 index (OEX) and the S&P 500 index (SPX), and is how its name was derived (100 vs. 500). The wonderful thing about the 1-5 spread is that it tends to expand as the market moves higher, and contract as the market moves lower. This provides an opportunity to those who embrace semi-complicated trades.
To understand how the spread between these two indexes works, you first need to know how professional traders calculate it. Suppose that the SPX is trading at 1,331 and the OEX is trading at 590. As you can see from the prices, the SPX is trading 741 points higher than the OEX, which would make for a very large spread. So by convention, two OEXs are traded for every one SPX. The math looks as follows: 1-5 = SPX - (OEX x 2); 1331 - (590 x 2 = 1180) = 151.
The 1-5 spread acts like a stock that is very highly correlated to the price of the indexes, but also has a high beta. As the market moves higher, the 1-5 spread usually expands, and as the market declines the cash spread (1-5) usually contracts. This makes an excellent tool with which to trade bearish positions using out-of-the-money puts and/or bullish positions using out-of-the-money calls.
Assume that the beta of the 1-5 spread to the SPX and/or OEX is about 1.6. On days the market is higher, the 1-5 cash spread tends to outperform on a percentage basis. The same thing happens to the downside on bearish days. Now you may be thinking, "Great, but how do I make money from this?"
Suppose that on May 4 you were bullish the market. You have many choices on how to profit from this opinion. You could sell a put spread, buy stock, buy a call spread, etc. Yet, all of these strategies come with their own risks if you are wrong. A well constructed 1-5 spread can be initiated to maximize profit if your opinion is correct, but has very little risk if you are wrong and the market declines.
On May 4, the 1-5 spread cash price was $142.92. When getting long the cash spread, you want to be long the SPX index and short the OEX index. This can be done with calls, call spreads, short puts or short put spreads. It even can be done with S&P futures against the OEX index.
Suppose that you were bullish and you wanted to place the trade on the close of May 4 for a May expiration on May 20 (May 19 last day of trading for SPX). Also, because of margin considerations, it’s best to trade an SPX spread against an OEX spread.
May 4, 2011: We can see from the table below that we can purchase the SPX 1335-1340 call spread for a $3.65 debit, and sell the OEX 595-600 call spread at $3.85 for a net 20¢ credit. This allows us to be bullish the market with the long SPX call spread while being protected with the short OEX call spread. If the market falls dramatically and both spreads expire worthless, we at least keep the 20¢ credit.
May 19, 2011: We fast forward until the day prior to expiration and see that the market didn’t move higher as we had anticipated. Instead, it sold off a tad. This is the downside to a long stock, long call, long call spread or short put position. Yet, the 1-5 spread was protected. We now can sell the long SPX spread out at $4.20 and buy back the short OEX spread for $2.10.
"Tale of the tape" (below) shows that we made money on both the SPX and OEX sides of the trade. Had we been bullish on the market and elected to get long an OEX call spread, we would have lost money. Instead we were bullish and decided to get long a derivative of the indexes as protection. We made 55¢ on the SPX side of the trade and we made $1.75 on the OEX side of the trade for a total of a $2.30 per-share profit. This is an example of why a carefully thought out and placed 1-5 spread can be a strong tool in your trading arsenal.
Susan Steward is chief economist for RandomWalkTrading.com.
Click here for a brief historical plotting of the SPX, OEX and 1-5 spread.