Chapter 13
Trading Index Options: Playing the Broader Market
An index option is a special type of option, with the underlying not a single stock but a representation of the broader market. Popular indices on which index options can be traded include the S&P 500, the Dow Jones Industrials, and many others.
The market for index options has been expanding rapidly in recent years, along with the popularity of more traditional options. According to the Chicago Board Options Exchange (CBOE), index option trading first exceeded one million contracts per day in 2008. By the end of 2008, volume above five million contracts per day was common. Growth in these highly specialized options has been dramatic.
index option
any option traded on a market index as the underlying, rather than on an individual stock.
Index options are traded on several U.S. exchanges, including the American (AMEX), CBOE, and Philadelphia (PHLX). Like the better-known stock-based option, all index options are guaranteed and cleared by the Options Clearing Corporation (OCC). Indices include not only well-known stock market indices (S&P 500, Nasdaq, and S&P 500, for example), but also debt securities, foreign currencies, and even economic indicators like the consumer price index (CPI).
An index value is calculated in one of several ways, and the methodology for valuation of the index will affect the movement in value of any related options. In addition, while all stock-based options in the United States can be exercised or closed at any time (American style), some index options cannot and are ruled using the European-style rules (meaning that options can be closed or exercised only on the day of expiration or within a short time frame immediately before expiration). Others adjust the valuation of options by contractually limiting the exercise window, which is a capped-style option. This distinction also matters to anyone considering opening trades in index options. In other words, the terms for index options are not as standardized as those for stock-based options.
Advantages to Trading Index Options
Many traders see an immediate advantage to trading an index rather than a number of individual stocks. By definition, an index tracks either a representative sample of the broader market or the whole market. It all depends on the number of issues included. For example, the Dow Jones Industrial Average (DJIA) has only 30 industrial companies but accounts for a major share of total capital in the U.S. market. The S&P 500 includes trends for 500 of the biggest companies in the United States. So depending on the index selected, the index represents an overall market trend that might not be experienced in a single stock. This means that risks are spread around; however, it also means that profit opportunities are going to be limited to overall market movement and not to the experience of any one stock.
So in trading index options in place of individual stock options, you achieve effective diversification of risk. In fact, the risk of individual stock options is replaced by a market-wide risk based on the structure of the index. For many traders, this is viewed as an advantage and perhaps as the only way to truly diversify an options trading portfolio.
If you were to attempt to approximate the movement of even a limited index such as the DJIA, you would still need to trade options in all of the 30 companies it lists. This is not practical for most traders and, in fact, would not necessarily be as effective as it is to trade in the options using the DJIA as the underlying security.
The specific price movement of an option will vary based on how the index is calculated and on how broadly the index represents the larger market. A broad-based index includes a larger number of components in many different market sectors. For example, the Nasdaq Composite Index includes all of the stocks listed on the exchange.
In comparison, a narrow-based index is limited to a smaller number of issues. For example, the Dow Jones Industrials includes the stocks of only 30 large so-called “industrial” companies. Even so, the DJIA represents nearly half of the total value of all U.S. companies listed and traded on the public exchanges.
Another very important distinction is the method used to calculate the numerical value of an index. Some indices are capitalization weighted, also called a market value-weighted index, including the Nasdaq Composite, S&P 500, and Wilshire 5000 indices.
Another group of indices are price weighted, which means the market value is used to calculate the index value. These are weighted for not only changing market value per share, but also for stock splits. So the divisor is continually changing for each of the components in a price-weighted index.
broad-based index
an index with a larger number of components and involving many different market sectors.
narrow-based index
an index using a small number of components rather than a larger or broader basis for its calculations.
capitalization weighted
description of the procedure used to calculate an index value, based on current market value for each of the components in the index.
price weighted
description of the procedure used to calculate an index value, based on current price and adjusted for all stock splits, for each of the components in the index.
A simplified method for creating an index involves adding together the total prices of all components and dividing the result by the number of securities. This method becomes inaccurate, however, whenever there is a stock split; so, over time, the nonweighted approach will become increasingly inaccurate.
Index components change periodically due to merger and acquisition activity, or because a particular company becomes less representative of the index itself, at least in the opinion of the publisher of the index. For example, the Dow Jones Company publishes numerous indices but does not announce how it determines whether a particular company should be dropped and replaced. An index is intended to accurately report movement in the broader market, so that investors and traders will be able to track markets and make sound judgments about current market conditions; so as long as an index accurately reflects these current conditions, it continues to have validity for traders. And options that are traded on these indices allow you to trade the overall market with a realistic expectation that the index will, in fact, move in line with market conditions.
Exercise and Expiration Rules
Unlike stock options, which contain standardized terms for all listed companies, the rules for index options will vary based on the exchange and on the publisher requirements and rules determined when the index was created.
The trading size of an index option is not uniform either, as it is with stock options. With stocks, each option is related specifically to 100 shares of the underlying stock. Index options are valued based on the value of the index, times a multiplier. This is usually $100, but not always; so before comparing prices of index options, check to ensure that multipliers are uniform among the various indices being followed.
cash settlement
a method for settling exercise of an index option, in which cash is paid rather than shares of stock being bought or sold.
Upon exercise of an index option, the holder does not receive a proportionate number of shares in each of the companies listed in the index. Instead, cash is exchanged based on the option value at the time of exercise. Accordingly, index options cannot be used for any strategy involving contingent purchase or sale of stock, a popular reason for employing stock-based individual options. This procedure is called cash settlement. One of the well-understood contractual rights for purchasers of stock options is the right to purchase 100 shares of stock (by exercising a call) or to sell 100 shares of stock (by exercising a put). That right does not exist for buyers of index options. The underlying security—the index value—is intangible, whereas the underlying value of a stock-based option—100 shares of stock—is tangible. This is what defines the difference in settlement procedures.
Exercise procedures are also different for index options. You can exercise your stock-based options at any time before expiration simply by entering an order, and this is usually executed immediately. But with an index option, you are required to notify your broker before a specified exercise cutoff time. This time for early exercise is not always identical for exercise on expiration day. It is crucial for an index options trader to determine the rules of exercise and to ensure that the applicable cutoff times are known in advance and observed. The cutoff deadline for index options often is not the same as the time for stock-based options.
exercise cutoff time
the specific deadline for exercise of index options, imposed by brokerage firms on traders, varying by index and by class of option.
When the holder of an index option exercises, assignment is made to a writer, who is then required to pay cash for the specified exercise value of the option. The procedure is the same as that for exercise of an option with stock as the underlying; but instead of delivering shares, the writer is required to settle in cash.
The timing of exercise will also rely on how the settlement value is calculated. Some index valuation is based on PM settlement, or the value of the index components at the close of a trading day. Many others are based on AM settlement , or valuation of the index components based on a trading day’s opening prices.
PM settlement
valuation of an index option based on the value of the index components at the close of trading on the day of exercise or expiration.
If an index is traded on American-style expiration, traders can exercise at any time on or before expiration. However, many indices are traded using European-style rules. This means that options can be exercised only during a specified and limited time period, and the period varies for each index. A capped-style rule, much like European style, may also limit the window when exercise is allowed for index options. In any of these situations, traders are allowed to close out their positions before expiration to avoid exercise, take profits, or avoid further losses.
AM settlement
valuation of an index option based on the value of the index components at the opening of trading on the day of exercise or expiration.
Index Option Strategies
Many of the strategies you can apply with stock-based options also work for index options. However, because settlement occurs in cash and not in stock, some stock-based exercise strategies will either not apply or will have different outcomes.
Following are many of the possible strategies you might consider with index options:
• Purchase of index calls. If you believe that the index is likely to rise in the near future, buying calls is the most basic strategy. With individual stocks, call purchasing requires that the underlying stock rise in value; with the index as the underlying, the index itself needs to move upward in index value (the equivalent of a stock’s price for stock options) in order to create a profit.
• Purchase of index puts. The opposite applies when puts are involved. If you believe that the underlying index is likely to fall in the near future, the index put will become profitable. Because the put is based on falling prices of the underlying, in-the-money declines in the index will be matched by increases in the index put’s value.
• Selling of index calls. If you think the index is going to fall in value, selling calls might be preferable to buying puts. However, if the index were to rise, the risk on this short strategy is, in theory, unlimited. The possibility of a broad-based index rising in double- or triple-digit ranges is probably unlikely in the short term, but it is impossible to quantify or limit the potential risk.
• Selling of index puts. Selling a put will be profitable as long as the index point value remains at or above the put strike. While the short call has a theoretical unlimited value, the short index put is actually limited. In the very worst-case scenario, an index could go to zero, but this is quite unlikely as components involving stocks will be cushioned by tangible book value of the companies. Futures-based or currency indices are equally unlikely to decline to the worst-case levels, so short put traders are probably able to quantify likely losses based on historical index movements, the breadth of components, and current market conditions and sentiment.
• Index spreading. Another way to make use of options with indices as the underlying is through spreading between two different indices. Because indices with similar underlying components (i.e., based on stock values) tend to track each other fairly consistently, the risk in spreading between indices is limited. However, if the spread involves indices with dissimilar components (i.e., stocks in one and commodities in another), the risk elements will be much greater, especially on the side of the spread that is shorted. (This risk can be mitigated, however, by using long calls and puts, rather than a long and short side in the spread.)
In picking an appropriate strategy, individual risk tolerance has to be a primary factor. For example, those who cannot tolerate a great deal of risk should limit their exposure to long call and put positions. The use of short index options is appropriate for those willing to assume greater risks and, unlike stock-based options, short positions cannot be covered by owning the underlying directly.
To “cover” a short position in an index option, there are some ways to approximate the protective features of a covered option. For example, you may own a long call that expires at the same date or later than an equivalent short call. As long as the long call’s strike is identical or higher than the earlier-expiring short call position, it is completely covered. If the long position’s strike is lower, it partially covers the short call, thus limiting the risk.
The same effect can be achieved with puts. A long put with a later or identical expiration or a later expiration than a short put covers the short position. If the long strike is identical or lower than the short strike, the short position is covered. When the long put’s strike is higher, the risk in the short position is limited to the difference between the two strikes.
A form of option covering is also accomplished when you hold long positions in the index itself, and then write calls against the same index. Each well-known market component has an equivalent index in which shares can be purchased; and many additional indices track quite well. For example, the Value Line Index contains many of the same stocks as the S&P 500. So owning one index while writing short calls on the other index may accomplish a version of “cover” for the short position. However, you should be quite familiar with these indices and their options before embarking on an advanced spread aimed at creating a covered call situation.
Structured Index Options
In addition to trading options directly, you can buy or sell positions in one of many “structured” products offered by one of the exchanges involved with index options. The CBOE offers many structured products aimed at specific index positions or strategies.
Smart Investor Tip
The CBOE offers options on over 40 market indices. To investigate further, check the CBOE web site at
www.cboe.com and go to the link “Index Options Overview.”
exchange-traded funds (ETFs)
types of mutual funds that trade on public exchanges like stocks, and consist of portfolios of predetermined, related securities known as the “basket of stocks.”
Related options are also available on index-like products, including exchange-traded funds (ETFs). An ETF is a type of mutual fund with a predetermined basket of stocks, which trades on the public exchange just like stocks (as opposed to having to buy or sell shares through the fund’s management). Because the portfolio of an ETF is known in advance, investors do not have to rely on quality of management to make wise investment decisions.
The CBOE facilitates trading of options on ETFs, which are settled in cash using American-style exercise rules. In some ETFs, the CBOE also offers long-term equity anticipation security (LEAPS) options. Every ETF has a theme or characteristic. For example, ETFs specialize in specific sectors, countries, or types of securities, making it possible to participate in very narrowly focused markets and hold proportionate values of many stocks with a single position. For this reason, the ETF form of mutual fund functions very much like an index, but with a narrower focus.
CBOE also offers options on holding company depositary receipts (HOLDRs), which are trust-issued receipts of beneficial ownership in groups of stocks. Originally created by Merrill Lynch, HOLDRs today are popular alternatives to market indices and ETFs. However, because the value of HOLDRs changes with market and sector trends, they are very similar to indices but, like ETFs, are more focused.
holding company depositary receipts (HOLDRs)
forms of beneficial ownership issued by trusts, providing investors with ownership in shares of predetermined stocks in a single industry or sector or sharing other attributes in common.
Smart Investor Tip
For more information about options on ETFs or HOLDRs through the CBOE, check their web site (
www.cboe.com) and go to the link “Options on ETFs & HOLDRs.”
CBOE also provides interest rate options, including options on U.S. Treasury securities; on futures through its own CBOE Futures Exchange; and on specialized types of options, including binary options. These are options based on the S&P 500 Index or on the CBOE Volatility Index. With different strike prices available, binaries trade much like stock-based options, but with one important difference. The buyer of a call binary option is paid $100 at close if the underlying index is higher than the call’s strike. If the underlying index is lower, the call buyer gets nothing. A put buyer receives $100 in the underlying index closes below the binary strike; if it is higher, the put buyer gets nothing. The long position of binary calls and puts can be closed before expiration, if desired. Premium levels for binary options vary between $1 and $100 per contract at the time of purchase, which varies depending on proximity between index level and strike and time until expiration.
binary option
an option based on an underlying index, which pays a fixed amount if the index is higher than a call’s strike or lower than a put’s strike at expiration.
weeklys
specialized options issued each Friday, which expire the following Friday.
The CBOE also markets short-term options with life spans of a single week or quarter. These are weeklys and quarterlys. Weeklys are issued each Friday and expire the following Friday. They are good alternatives to trading traditional stock options with timing at or near important events like earnings announcements or dividend dates. The quarterlys are issued on the final business day of each calendar quarter, and they expire three months later.
quarterlys
specialized options issued on the last day of each calendar quarter, which expire at the end of the following quarter.
FLEX option
a type of option whose terms—including expiration date, striking price, and exercise terms—can be modified during the period a position remains open.
Yet another innovation is the flexible exchange (FLEX) option, a CBOE product whose terms can be modified. These include the expiration date, striking price, and exercise terms (American or European).
In addition to providing FLEX options on several individual stocks, the CBOE also offers them on the S&P 500, S&P 100, Nasdaq 100, Russell 2000, and Dow Jones Industrial Average.
A great deal of variety and flexibility in the markets for index options and similar products makes option investing far more expansive than the traditional stock-based option. While the range of strategies available on traditional listed options continues to make this the most appealing to the greatest number of traders, index option trading has great potential. It broadens the possibilities for diversification of a stock portfolio and for creative advanced strategies.
As with all types of options, the risk levels involved should rule the decision to use to not use a particular strategy or type of option. Another concern is how profits will be treated and timed for tax purposes. The next chapter explains risks and taxes for option trading.
