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The index options market developed as a tool for managing risk. Traders could add exposure to the market by buying options, hedge exposure by selling options, or try to capture income from a “Buy-Write” strategy. Generally speaking, options traders didn’t care which way the market was moving, as long as it was moving.

The new natural gas index from International Securities Exchange [ISE] turns that all on its head. Rather than trying to capture the maximum movement in the market, the index has screens that dampen volatility. Rather than simply trying to track the market, the index tries to beat it.

Developed in partnership with Revere Data, and launched on October 10, this index is the ISE’s first foray into the “enhanced indexing” field. It is also a sign of the times, showing that the options industry is reaching out beyond its traditional customer-base and targeting retail-oriented long-term investors.

Selecting For Performance
It is not surprising that the ISE developed a natural gas index. Like most commodities, natural gas is a hot topic, and the ISE has been aggressively expanding its index business into hot new areas for the better part of the decade.

“We look at a variety of things before we move forward with a new index,” says Kris Monaco, who heads up the index development business at ISE. “What’s in the press, what people are talking about, what’s tradable… Commodity prices are headline news, and this seemed like a specific sector that we could target to further ISE’s brand, and also to create an interesting tradable product.”

But the new index is not a straight natural gas index … not by a long shot. In addition to some nifty data mining by Revere Data that aims to separate real natural gas companies from integrated energy firms (more than 50 percent of a company’s proven energy reserves must come from natural gas), the index features a four-part screening test that tries to pick out stocks that will perform well in the market. Call it an alpha-seeking index, a fundamental index or an enhanced index; the point is that this index, like the bogies behind the PowerShares ETFs, selects for performance.

“The intent (of the index) is really not to mirror the price of natural gas,” said Monaco. “But to capture the growth of this sector. The question was: how do you come up with a really good group of stocks – a high-quality portfolio – that could really take advantage of this growth sector?”

The screening is fairly simple. Stocks that meet Revere’s criteria as natural gas stocks, along with basic liquidity tests, are ranked by four factors:

* Price-to-earnings ratio (the lower the better)
* Price-to-book ratio (the lower the better)
* Return-on-equity (the higher the better)
* Correlation to the price of natural gas

The group combines these scores on an equal basis, and then chooses the top 30 stocks to compose its index. Those components are weighted equally in the portfolio.

What’s so unusual – for an options index – is that three of the four screens are naturally associated with decreased volatility. Since volatility is the lifeblood of most options traders, these indexes must be aimed at a different market – a market made up of more retail-oriented investors looking for long-term exposure than of short-term traders looking to hedge the market.

And that’s almost what the ISE is suggesting.

“When you chart natural gas against index, the index outperforms,” said Monaco. “That’s what it was meant to do: retain some of the volatility to appeal to options traders, but also allow people to make directional investments in natural gas itself.”

Retail Investor And Long-Term Trends
The ISE’s movement shouldn’t surprise me. It is, after all, the “people’s option exchange,” and its index development business has focused on the retail end of the spectrum for some time: how else do you explain indexes like the SIN-Dex, which features companies involved in “sindustries” like alcohol and gambling?

But creating an enhanced index takes things one step further. The new index explicitly targets long-term performance, and includes screens that actually dampen volatility.

When it launched the index, the ISE put out a statement positioning it as a traditional options benchmark.

“As interest in alternatives to oil grows,” said Bruce D. Goldberg, ISE's Chief Marketing Officer, “options on the ISE-REVERE Natural Gas Index will provide investors with an opportunity to gain exposure to or hedge existing positions to protect against natural gas price movements.”

But that’s not quite right. If you wanted to hedge yourself against natural gas price movements, you would most likely trade natural gas futures or options.

The new ISE-Revere index is a different ball of wax. Traders working this index are looking for something more than a hedge against volatility; they’re looking for long-term performance from a red-hot commodity sector.

The only question is: When will the ISE branch away from the options market and launch an ETF?

Editor's note: For a list of ISE-Revere components, click here.

Source: International Securities Exchange Launches Natural Gas Index