Buying Index Options

Options are actually more basic instruments than futures or ETFs. You can replicate any future or ETF with options, but the reverse is not true. Options offer the investor far more strategies than futures. Such strategies can range from the very speculative to the extremely conservative.

Suppose you want to be protected against a decline in the market. You can buy an index put, which increases in value as the market declines. Of course, you have to pay a premium for this option, very much like an insurance premium. If the market does not decline, you have forfeited your premium. But if it does decline, the increase in the value of your put has cushioned, if not completely offset, the decline in your stock portfolio.

Another advantage of puts is that you can buy just the amount of protection that you like. If you want to protect yourself against only a total collapse in the market, you can buy a put that is way out-of-the-money, in other words, a put whose strike price is far below that of the current level of the index. This option pays off only if the market declines precipitously. In addition, you can also buy puts with a strike price above the current market, so the option retains some value even if the market does not decline. Of course, these in-the-money puts are far more expensive.

There are many recorded examples of fantastic gains in puts and calls. But for every option that gains so spectacularly in value, there are thousands of options that expire worthless. Some market professionals estimate that 85 percent of individual investors who play the options market lose money. Not only do options buyers have to be right about

13 The original article was published in 1973: Fischer Black and Myron Scholes, "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, vol. 81, no. 3, pp. 637-654. Fischer Black was deceased when the Nobel Prize was awarded in 1997. Myron Scholes shared the Nobel Prize with William Sharpe and Bob Merton, the latter contributing to the discovery of the formula.

the direction of the market but also their timing must be nearly perfect, and their selection of the strike price must be appropriate.

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