The Good, Bad & Ugly of Alpha Index Options

What are Alpha Index Options?

Alpha Index options are an innovative new product for retail traders looking to trade relative as opposed to absolute performance and they come with the added bonus that transactions fees are lower than trading the underlying securities separately.  This is due to the fact the security on which the alpha options are based is really a coupled pair of securities.  The unintended consequence of the coupling is that brokers will see less trading and hence lower transaction revenues as traders no longer need to buy one security long and sell another short in two separate transactions in order to create the same net position.

From the retail trader's perspective, on days when the markets are down, the newly issued AVSPY which compares Apple to the SPY can trade higher intra-day despite both Apple and SPY moving lower during parts of the day.  So, traders who expected Apple to rise on a given day more than the SPY can still see the AVSPY rise even though they may have been wrong on their estimation of direction; they are profiting when Apple falls to a lesser extent than the S&P 500 SPDR

Nonetheless, retail traders should be somewhat wary still given that liquidity levels are low and bid-ask spreads are still quite wide.

Another caveat which retail traders should be aware of is that each alpha index uses a proprietary calculation so a degree of opacity exists making it hard to know with certainty how much the Alpha Index will move as each of the securities on which the index is based move.

Above all, retail traders should pay attention to the fact that alpha index options are trades based on correlation so relative as opposed to absolute performance is what counts.

Also keep in mind that the options expire worthless so not only are you trading correlation but you must predict what the movement of the alpha index will be over a certain time frame.

Guess the right direction, but wrong time frame and the long options will suffer (though short options would benefit in this case).

And from a volatility perspective, on days where the S&P 500 rises a lot but the comparison stock drops considerably, say on an earnings announcement, expect exaggerated moves in the alpha index and accompanying options.

Finally, be wary of recency bias in trading these positions.  The stocks chosen in each Alpha Index have been market leaders but just as they outperformed during the rally so too can they lead the way down during a correction.

Next up for release is the Google Versus SPY Alpha Index which begin trading on April 20th.

Bottom line, if you had engaged previously in pairs trading, going long Apple, short the SPY, this is a great way to enter the trade with lower transaction fees.

But dangers exist: bid-ask spread, correlation, options expiration and opacity

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