Index Options - Part 4

Basic Strategies

The versatility of index options stems from the variety of strategies available to the investor. The most basic uses of index options are explained in the following examples. These examples are based on hypothetical situations and should only be considered as examples of potential trading approaches. Other investment strategies that might be used with equity options, such as spreads and straddles, can be employed with index options. For more detailed explanations, contact your brokerage firm or the exchanges where index options are traded.

Note: For purposes of illustration, commission and transaction costs, tax considerations and the costs involved in margin accounts have been omitted from this example. These factors will affect a strategy’s potential outcome, so always check with your brokerage firm and tax advisor before entering into any of these index options strategies. For illustrative purposes, the index option positions in all of the following examples are shown to be held until expiration. The premiums are intended to be reasonable, but in reality will not necessarily exist at or prior to expiration for a similar option.

Strategy 1: Buying Index Calls

Market Outlook: Bullish over the short term

Goal: Positioning to profit from an increase in the level of the underlying index

You are anticipating an advance in the broad market or market sector measured by the underlying index in the near future. You want to take an aggressive position that can provide a great deal of leverage. This decision is made with the understanding that there is a possibility you may lose the entire premium you pay for the option.

An index call option gives the purchaser the right to participate in underlying index gains above a predetermined strike price until the option expires. The purchaser of an index call option has unlimited profit potential tied to the strength of advances in the underlying index.

Scenario

Assume the underlying index that interests you is symbolized as XYZ and is currently at a level of 200. You decide to purchase a six-month XYZ 205 call for a quoted price of $4.75 per contract. Your net cost for this call is $475 ($4.75 x 100 multiplier). You are risking $475 if the underlying index level is not above the strike price of 205 when the XYZ call expires. The break-even point (BEP) at expiration is an XYZ index level of 209.75 (strike price 205 + premium paid $4.75) because the call will be worth its intrinsic value of $4.75, which is what you originally paid for it. The higher the XYZ index settlement value is above the BEP at expiration, the greater your profit.

Possible Outcomes at Expiration

1. XYZ index level above the break-even point (209.75):

If at expiration XYZ index has advanced to 215, the XYZ 205 call will be worth its intrinsic value of $10 (settlement value 215 - strike price 205). Your net profit in this case would be $525 (settlement amount $1000 received from exercise - net cost of call $475).

Buy XYZ Index 205 Call at $4.75 with Index at 200 Net Cost for Call = $475

*Exclusive of commissions, transaction costs and taxes.

2. XYZ index level between strike price (205) and BEP (209.75):

If at expiration XYZ index has advanced to 207, the XYZ 205 call will be worth its intrinsic value of $2.00 (settlement value 207 - strike price 205). You could exercise the option and receive the settlement amount of $200 ($2.00 intrinsic value x 100 multiplier). This amount would be less than the net amount paid for the call ($475), but it would offset some of that cost. The net loss in this case would be $275 (net cost of call $475 - settlement amount $200 received from exercise). This loss represents a little more than half of your initial investment.

3. XYZ index level below strike price (205):

If at expiration XYZ index has declined to 198, the call would have no value because it is out-of-the-money. You will have lost all of your initial investment, a net of $475. The net premium paid for an index option represents the maximum loss for an option purchaser.

Note: No matter how far XYZ declines below the strike price, the loss will not exceed $475.

Strategy 2: Buying Index Puts

Market Outlook: Bearish over the short term

Goal: Positioning to profit from a decrease in the level of the underlying index

You are anticipating a decline in the broad market or market sector measured by the underlying index in the near future. You want to take an aggressive position that can provide a great deal of leverage.

This decision is made with the understanding that there is a possibility you may lose the entire premium you pay for the option.

An index put option gives the purchaser the right to participate in underlying index declines below a predetermined strike price until the option expires. The purchaser of an index put option has substantial profit potential tied to the degree of declines in the underlying index.

Scenario

Assume the underlying index that interests you is symbolized as XYZ and is currently at a level of 200. You decide to purchase a six-month XYZ 195 put for a quoted price of $3.90 per contract. Your net cost for this call is $390 ($3.90 x 100 multiplier). You are risking $390 if the underlying index level is not below the strike price of 195 when the XYZ put expires. The BEP at expiration is an XYZ index level of 191.10 (strike price 195 - premium paid $3.90) because the put will be worth its intrinsic value of $3.90, which is what you originally paid for it. The lower the XYZ index settlement value is below the break-even point at expiration, the greater your profit.

Possible Outcomes at Expiration

1. XYZ index level below the BEP (191.10):

If at expiration XYZ index has declined to 185, the XYZ 195 put will be worth its intrinsic value of $10 (strike price 195 - settlement value 185). Your net profit in this case would be $610 (settlement amount $1000 received from exercise - net cost of put $390).

2. XYZ index level between strike price (195) and BEP (191.10):

If at expiration XYZ index has declined to 193, the XYZ 195 put will be worth its intrinsic value of $2.00 (strike price 195 - settlement value 193). You could exercise the option and receive the settlement amount of $200 ($2.00 intrinsic value x 100 multiplier). This amount would be less than the net amount paid for the put ($390), but it would offset some of that cost. The net loss in this case would be $190 (net cost of put $390 - settlement amount $200 received from exercise). This loss represents a little less than half of your initial investment.

3. XYZ index level above strike price (195):

If at expiration XYZ index has advanced to 202, the put would have no value because it is out-of-the-money. You will have lost all of your initial investment, a net of $390. The net premium paid for an index option represents the maximum loss for an option purchaser.

Note: No matter how far XYZ advances above the strike price, the loss will not exceed $390.

Buy XYZ Index 195 Put at $3.90 with Index at 200 Net Cost for Put = $390

*Exclusive of commissions, transaction costs and taxes.

Read more about options trading strategies in the next section of this guide: Part 5. When you feel more knowledgeable about this financial derivative, open your personal investing account with Firstrade today.

© 2023 The Options Industry Council. All Rights Reserved. Visit us online at www.optionseducation.org