Enhanced indexation using both equity assets and index options

Abstract

In this paper we consider how we can include index options in enhanced indexation. We present the concept of an “option strategy” which enables us to treat options as equivalent to an asset. An option strategy for a known set of options is a specified set of rules which detail how these options are to be traded (i.e. bought, rolled over, sold) depending upon market conditions. We consider option strategies in the context of enhanced indexation, but we highlight how they have much wider applicability in terms of portfolio optimisation. We use an enhanced indexation approach based on second-order stochastic dominance (SSD). We show that a SSD cutting plane solution approach can be extended to solve, to proven optimality, cardinality constrained SSD problems with limitations on the proportion of the portfolio invested in any asset. We consider monthly index options for the S&P 500, using a dataset of daily stock prices over the period 2017–2025 that has been manually adjusted to account for index composition. This dataset is made publicly available for use by future researchers. Our computational results indicate that introducing option strategies in an enhanced indexation setting offers clear benefits in terms of improved out-of-sample performance. This applies whether we use equities or an exchange-traded fund as part of the enhanced indexation portfolio.