Index Options

Although ETFs and index futures are very important to investment professionals and institutions, the options market has caught the fancy of many investors. And this is not surprising. The beauty of an option is embedded in its very name: you have the option, but not the obligation, to buy or sell stocks or indexes at a given price by a given time. For the option buyer, this option, in contrast to the futures, automatically limits your maximum liability to the amount you invested.

There are two major types of options: puts and calls. Calls give you the right to buy a stock (or stocks) at a fixed price within a given period of time. Puts give you the right to sell a stock. Puts and calls have existed on individual stocks for decades, but they were not bought and sold through an organized trading system until the establishment of the Chicago Board Options Exchange (CBOE) in 1974.

What attracts investors to puts and calls is that liability is strictly limited. If the market moves against options buyers, they can forfeit the purchase price, forgoing the option to buy or sell. This contrasts sharply with futures contracts with which, if the market goes against buyers, losses can mount quickly. In a volatile market, futures can be extremely risky, and it could be impossible for investors to exit a contract without substantial losses.

In 1978, the CBOE began trading options on the popular stock indexes, such as the S&P 500 Index.11 The CBOE options trade in multiples

11 In fact, the largest 100 stocks of the S&P 500 Index, called the "S&P 100," comprise the most popularly traded index options. Options based on the S&P 500 Index are more widely used by institutional investors.

of $100 per point of index value—cheaper than the $250-per-point multiple on the popular S&P 500 Index futures.

An index allows investors to buy the stock index at a set price within a given period of time. Assume that the S&P 500 Index is now selling for 1,400, but you believe that the market is going to rise. Let us assume you can purchase a call option at 1,450 for three months for 30 points, or $3,000. The purchase price of the option is called the premium, and the price at which the option has value when it expires—in this case 1,450—is called the strike price. At any time within the next three months you can, if you choose, exercise your option and receive $100 for every point that the S&P 500 Index is above 1,450.

You need not exercise your option to make a profit. There is an extremely active market for options, and you can always sell them before expiration to other investors. In this example, the S&P 500 Index will have to rise above 1,480 for you to show a profit if you hold until the expiration, since you paid $3,000 for the option. But the beauty of options is that, if you guessed wrong and the market falls, the most you can lose is the $3,000 premium you paid.

An index put works exactly the same way as a call, but in this case the buyer makes money if the market goes down. Assume you buy a put on the S&P 500 Index at 1,350, paying a $3,000 premium. Every point the S&P 500 Index is below 1,350 at expiration will recoup $100 of your initial premium. If the index falls to 1,320 by expiration, you have broken even. Every point below 1,320 gives you a profit on your option.

The price that you pay for an index option is determined by the market and depends on many factors, including interest rates and dividend yields. But the most important factor is the expected volatility of the market itself. Clearly, the more volatile the market, the more expensive it is to buy either puts or calls. In a dull market, it is unlikely that the market will move sufficiently high (in the case of a call) or low (in the case of a put) to give options buyers a profit. If this low volatility is expected to continue, the prices of options are low. In contrast, in volatile markets, the premiums on puts and calls are bid up as traders consider it more likely that the options will have value by the time of their expiration.12

The price of options depends on the judgments of traders as to the likelihood that the market will move sufficiently to make the rights to buy or sell stock at a fixed price valuable. But the theory of options pricing was given a big boost in the 1970s when two academic economists, Fischer Black and Myron Scholes, developed the first mathematical for

12 Chapter 16 will discuss a valuable index of option volatility called VIX.

mula to price options. The Black-Scholes formula was an instant success. It gave traders a benchmark for valuation where previously they used only their intuition. The formula was programmed on traders' handheld calculators and PCs around the world. Although there are conditions when the formula must be modified, empirical research has shown that the Black-Scholes formula closely approximates the price of traded options. Myron Scholes won the Nobel Prize in Economics in 1997 for his discovery.13

Stocks and Shares Retirement Rescue

Stocks and Shares Retirement Rescue

Get All The Support And Guidance You Need To Be A Success At Investing In Stocks And Shares. This Book Is One Of The Most Valuable Resources In The World When It Comes To

Get My Free Ebook


Post a comment