The Importance Of Hedging
In this commentary, I’ll follow up on the discussion from Tuesday, October 12, regarding the following e-mail from a subscriber:
“
On Oct. 5, when the S&P was around 1300, I bought some OEX Nov. 740 calls for 3 1/4. Today, Oct. 8, the S&P cash has increased nicely to around 1336, but the bid on my 740 calls is only 2 5/8. What happened?“
I discussed the influence of VIX on OEX option positions last time, but you should also notice that the subscriber purchased OEX calls but is looking at the S&P, a closely related, but nonetheless slightly different market.
The S&P and the OEX do not track each other precisely. The S&P is typically around twice the OEX, but this is not a strict relationship. Figure 1 shows this ratio over the period since July.
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| Figure 1.  S&P 500/OEX ratio. Â
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| Date: | 10/5/99 | 10/8/99 |
|---|---|---|
| S&P/OEX: | 1.883 | 1.937 |
September and now has started rising again. You can see that the S&P/OEX
ratio is typically around 2.0, but it is rarely–in fact, never in this time
period–exactly equal to 2.0. The table (above, right) shows this ratio at the
close on each of the days we discussed in the October 12 commentary.
This ratio increased between 10/5/99 and 10/8/99, which tells you that the OEX failed to increase as much as the S&P on these days. The S&P increased over this time period by about 35 points, and if the 2-to-1 ratio held strictly, you would expect the OEX to increase by about half that amount, or approximately 17 points. But in fact, the OEX increased by less than 7 points, from 682.71 to 689.91.
Using the S&P to time the OEX is not quite comparing apples to oranges, but perhaps comparing Washington apples to California apples. If your timing is keyed to the S&P, this is an additional risk you must endure. There are various solutions to this problem. The easiest is to key your timing to the OEX itself.