Suppose we wanted to create a bearish position to take advantage of a possible decline in the markets during September, but we didn’t want to lose money if the markets advanced. Because we know about this 1-5 phenomenon, we can initiate a position in which we achieve both goals.
There are many ways to calculate the relationship between the two indexes, but convention simply is to double the price of the OEX and subtract it from the SPX. With the SPX at 1385.97 and the OEX at 637.17, the cash spread would come out to be $111.63 [SPX 1385.97 – (2 X OEX 637.17)].
Suppose that you were bearish on the markets and could infer that the cash difference between the SPX and OEX would collapse. We saw that the markets closed with the cash spread equaling $111.63 on Friday, July 27.
Long SPX spread: We could construct a long SPX put spread that is out-of-the-money by 2.6% using the purchase of the 1350 put ($8.40 close) and the sale of the 1340 put ($6.95 close). This spread will cost a debit of $1.45.
Short OEX spread: To hedge the above SPX long spread, we decide to sell an OEX (637.17) spread against it that is 2.69% out-of-the-money. We sell the 620 put ($3.75) and buy the 610 put ($2.125) to receive a credit of $1.625.
We bought a long SPX spread that is closer to the money for $1.45 and sold an OEX spread a tad further out-of-the-money at $1.625. We take in a credit of $0.175. We also expect the markets to fall with the SPX falling faster, thus the long spread will go in-the-money before the short spread does.
Let’s say that the SPX falls 3%. We will make an assumption that the OEX will fall only 2.8%. The ending prices of the indexes will then be: SPX = 1344.39; OEX = 619.33.
“Tale of the tape” prices out the spreads individually and collectively from a market price of $0 (1st row), to down 3% & 2.8% (2nd row) and unchanged (3rd row).
The table shows the spread is protected even if the market is totally devastated (SPX and OEX price at $0). Also, if the market does fall as we expect and the SPX falls slightly more than the OEX (to 1344.39 and 619.33, causing a cash spread price of $105.73), then a significant profit can occur. Last, if the markets stay unchanged for the month, the spread still makes a small profit. Obviously both spreads will have expired worthless and we keep the initial credit (not including commissions).
Even though this is a remedial example illustrating how the 1-5 spread works, if you study this and see the numerous ways to use it, you will find this spread worthwhile. It is hard to beat as a way of taking cheap and protected shots that have an opportunity to make money.
J.L. Lord is an analyst and author for options education firm RandomWalkTrading.com.