are involved in a fender bender (yes, it wasthe other driver’s fault) and that you make a claim against your policy. The “insurance option” you hold does not give you the right tobuy a new car or to sell the damaged one, but only the right toreceive a payment in cash. This payment will be determined by theterms of the policy based on the deductible and the repair estimatefrom Joe’s Garage. Your car insurance policy settles in cash, not ina physical commodity.Equity options settle in shares of stock: exercise a call and you get100 shares of the underlying; exercise a put and you have to deliver100 shares of stock. Index options settle in cash, in the same fashionas your car insurance. Purchasing an index option does not give youthe right to buy or sell anything but simply the right to receive acash amount that will be determined by the terms of the option.Settlement AmountThe short answer as to how an index option’s cash settlementamount is calculated is that it’s equal to its in-the-money amount.The longer answer must take into account the fact that there are twodifferent methods of calculating this amount.Some index options (such as the options on the Standard & Poor’s100 Index, OEX®) are known as P.M. settlement options. The level ofthe index that is used to calculate the cash settlement is the closingvalue the day an option is exercised. Assume that on a given daythe OEX index closes at 596.40. An investor who earlier had purchased the 580 calls decides to exercise these. His account will becredited $1,640 per contract, calculated by taking the in-the-money
Options on Exchange-Traded Funds and on Indices
173
amount of $16.40 (596.40 less the strike of 580) and multiplying by100 (as if the options had 100 shares of underlying). This is the easier of the two methods of calculating the settlement amount, butwith the exception of the OEX, very few options are P.M. settlement.Other index options are classiﬁed as A.M. settlement. This doesnot mean that the settlement value is based on the index’s openingvalue. It’s slightly more complicated. As an example, take theoptions on the Standard & Poor’s 500 Index, SPX. There are 500stocks in this index (don’t laugh—there are eleven football teams inthe Big Ten Conference), and on the day the options settle each stockopens for trading either on the NYSE or on Nasdaq. Some stockswill open for trading at 9:30 eastern, some will open at 9:31, othersat 9:33, and so on, until the last one opens at 9:44, delayed becauseof an order imbalance. Take the opening prices of all of these 500stocks, from the ﬁrst one at 9:30 through the last one at 9:44, and calculate the value of the index. This is the index level that is used tocalculate the in-the-money and settlement amounts.The A.M. settlement calculation has led to some bizarre occurrences. One day, for example, stocks were opening sharply lowerthan the previous day’s close because of some negative news. As thenews was reinterpreted in a more neutral light, stocks startedbouncing back. Most stocks’ opening prices ended up being theirlows for the day. And because quite a few stocks had delayed openings, by the time all 500 stocks had started trading, the market wason the mend. The A.M. settlement value ended up falling outside ofthe index’s range for the day. It was lower than the low because itconsolidated all of the bad news into one number. Nevertheless, thetrend has been toward A.M. settlement and most new index optionsthat are listed for trading fall into this category.
European versus AmericanNo, this is not about ﬁgure skating, but about restrictions—or lackthereof—on the right to exercise options. All equity options andsome index options are American-style, which means that theirholders may exercise them on any business day up to and including their last trading day. Most index options are European-style,meaning that they may only be exercised immediately prior to expiration. Options with no early exercise are becoming the norm with
174
The Options Strategist
the new index options listings. If this feature sounds like a negativefor the option holder, it can also be viewed as a positive for thewriter because there is no risk of early assignment.Last Trading DayThe last trading day for equity options is the third Friday of theexpiration month. With index options there are two different lasttrading days, depending on the option.■
The third Friday of the expiration month, as with equities. OEX,options on the Standard & Poor’s 100 Index, is an example.
■
The Thursday preceding the third Friday of the expiration month;example: SPX, options on the Standard & Poor’s 500 Index. Mostindex option classes now cease trading at the close of businesson the Thursday preceding expiration Friday. With no trading onFriday, these options can have an A.M. settlement based on Friday’s opening prices.
Whichever index option class you trade, it is a good idea to verify which is their last trading day. Check the website of the exchangewhere they trade.Broad and NarrowIndex options have been listed on most of the obvious candidates:the Dow Jones Industrial Average®, the Standard & Poor’s 500Index, the Russell 2000® Index, and other familiar names. They havealso been listed on numerous narrow indices that for the most partcover just one sector of the market. Some, like the Dow Jones Transportation AverageSM, you will recognize; others, like the CBOE GoldIndex, you may not.As of this writing 25 broad-based and 39 narrow-based indiceshave options listed. In terms of liquidity, they run the gamut—fromthose that can absorb institutional orders for thousands of contractsto those that are traded only by appointment. Check trading volume and open interest before ﬁring in your market orders.Narrow-based index options and equity options trade until 4:02P.M. eastern time, for two minutes after the closing bell in New York,
Options on Exchange-Traded Funds and on Indices
175
whereas broad-based options can be bought and sold until 4:15 P.M.eastern time.
Fractional UnderlyingsThe most recognized name in indices is the Dow Jones IndustrialAverage. Are there options listed on this index? Technically no, butin reality yes. There are options listed on the DJX index, which happens to be equal to one one-hundredth of the DJIA. For example, ifthe DJIA is 10,123.47, then the DJX is set at 101.23 and the optionson the DJX trade off this reduced level.The reason for trading off of a reduced value of the actual indexis to keep option premiums at a manageable level. A one-month atthe-money call on an index of 10,000 might be quoted as $200–$210.With a 100 multiplier that would represent $20,000 per contract. Thiswould severely limit the number of participants.To make life more interesting, some options classes have optionson both the full-size index and on a reduced value. For example, theshort-term options on the Standard & Poor’s 100 Index (OEX) tradeoff the full value of the index, whereas the LEAPS on the same indextrade off one-ﬁfth the index value. It is unclear if the number ofoptions traders gained by keeping the option premiums lower isgreater than the number lost due to confusion.
Parallel UniversesSome indices with cash-settled options (as opposed to options onETFs, discussed earlier) also have exchange-traded funds that trackthem. For example, SPX, the options on the Standard & Poor’s 500Index, settle in cash; the Spiders (SPY) are an ETF that tracks theS&P 500 Index on a reduced-value basis. SPX and SPY live in parallel universes, both closely tracking the underlying index, but aposition in SPX, which settles in cash, will never become or eliminate a position in SPY.This opens up hedging opportunities, buying SPX puts to hedgean SPY position for example, but the cash settlement feature of theoptions means that if an investor wants to unwind his total position(long SPY, long SPX puts) she must do so in two transactions (sell
176
The Options Strategist
SPY, sell SPX puts) and not through the exercise of the put, as wouldbe the case with options on equities or ETFs.
Strike Price IntervalsBecause indices tend to be less volatile than equities, some indexoption classes have their strike price intervals set at two and sometimes one point, not the $2.50 and $5 intervals associated withequity options.
Index Options: Investment StrategiesThere are pluses and minuses to hedging security positions withcash-settled options. The key is understanding what should andwhat should not be attempted.
Buying Protective PutsAn investor who owns 600 shares of stock and is nervous about theshort-term prospects for either this stock in particular or the market in general has one simple hedging strategy to pull out of his bagof tricks: purchase six put options on the stock in question.What about the investor who owns shares of an ETF on whichoptions are listed, equity mutual funds, or simply a diversiﬁed stockportfolio, and who is also looking for some short-term insurance?This is where index options come in, offering the same type of protection, but usually with a twist.Let’s start with a relatively straightforward example. An investorwho owns 2,000 shares of SPY (the ETF that tracks the Standard &Poor’s 500 Index) is worried about upcoming economic news andwould like to hedge his position for the next 60 days by purchasingput options. In this situation the choice of index options is not complicated: SPX options have as underlying the same Standard &Poor’s 500 Index, offering perfect insurance.This investor will have to decide on which expiration date andwhich strike price to choose, but he will also have to calculate howmany put options are required to fully hedge his portfolio. Hedg-
Options on Exchange-Traded Funds and on Indices
177
ing 2,000 shares usually requires purchasing 20 puts, but if ETFs andindex options are involved, one must ﬁrst verify the “size” of theoptions relative to the underlying. The following quotes should helpus in this process (note: options have eight weeks until expiration):S&P 500 Index:SPYSPX April 1100 put:SPX April 1075 put:SPX April 1050 put:
1116.84$112.14$23.80–$25.80$16.70–$18.20$13.70–$15.20
The SPY shares are valued at one-tenth the level of the index. Theslight premium you are seeing reﬂects the dividends accruing onthe Spiders. The index is calculated from the prices of the component stocks ignoring dividends, whereas the Spiders reﬂect thevalue of the component stocks plus the dividends that have accruedsince the last quarterly ex-dividend date.Our investor owns 2,000 shares, which have a current value of$224,280. Each SPX option has an underlying value of $111,684,equal to the level of the index times the 100 multiplier. Two puts,not 20, should, therefore, be purchased to hedge this investor’sposition.Let’s assume our investor decides to purchase the 1050 puts,which are 6% out-of-the-money. He can live with a 6% drop in thevalue of his portfolio but would like protection below that level. Hepurchases two of the April 1050 puts at $15.20, for a total cost ofTable 7.3
Index LevelPrice ofat Expiration 1050 Put
Value of 21050 Puts
Cost of 21050 Puts
Value of2000 SPY
TotalPortfolioValue
1150
$0
$0
($3,040)
$230,900
$227,860
1100
$0
$0
($3,040)
$220,900
$217,860
1050
$0
$0
($3,040)
$210,900
$207,860
1000
$50
$10,000
($3,040)
$200,900
$207,860
950
$100
$20,000
($3,040)
$190,900
$207,860
178
The Options Strategist
$3,040. Table 7.3 calculates the value of his Spiders and put optionsat option expiration. We assumed that the Spiders will be tradingwith the same $0.45 premium they currently carry.The worst-case scenario for this investor is a loss of $16,420, whichoccurs at an index level of 1050 and comes from the $3,040 put premium and the $13,380 drop in the value of the portfolio. As theindex falls below 1050, the losses on the portfolio become larger butare fully compensated by the increase in the value of the putoptions. If the market goes up in value, proﬁts accrue on the Spiders but are reduced by the $3,040 cost of insuring the portfolio.If the Standard & Poor’s 500 Index is trading below the puts’strike price of 1050 at the April option expiration, our investor willhave to decide whether to continue holding his Spiders or to liquidate his shares and move into cash or other investments. If his viewis that the market correction has run its course and he wants tomaintain his long SPY position, he need do nothing. His puts, beingin-the-money, will automatically be exercised and his account credited with the puts’ intrinsic value. If the index has dropped to 1000,he will receive $10,000, which he can reinvest elsewhere.If, on the other hand, this investor decides that the market downturn is just starting and it is now best to move out of equities, he willhave to liquidate his long SPY shares in a separate transaction. Hestill will receive the cash settlement from his long puts, but he willneed to place a sell order with his broker in order to move out of hisSpiders. For the hedge to be perfect, the price at which he sells hisSPY shares would have to be equal to the corresponding index levelused in calculating the options settlement value. This will be virtually impossible to achieve.SPX options are A.M. settlement, and to replicate the option’s settlement price, an investor would have to enter market-on-open sellorders for the 500 component stocks. Institutions that actually holdall 500 stocks are able to do this, but our investor owns Spiders, notthe 500 component stocks. To minimize slippage, he should probably instruct his broker to sell his Spiders on the opening on expiration Friday. The odds that the price he obtains for his shares and thesettlement value of the SPX options will be the same are minimal,but unless there is a sharp drop at the opening followed by a strongrally, the two values should be close enough not be a major sourceof concern. (A strong opening followed by a sharp decline would
Options on Exchange-Traded Funds and on Indices
179
probably end up being in his favor.) So the “perfect” hedge wedesigned falls a little short of that designation.If the investor above was hedging not Spiders, but shares in anS&P 500 Index mutual fund, every step of the process would remainthe same unless the decision was made to liquidate the mutual fundshares. Since most mutual funds are bought and sold based on thetrading day’s closing value, our investor would have to decidewhether to liquidate his fund on the Thursday’s close, and assumeovernight risk, or the Friday’s close, and assume one trading day’sworth of risk. Hedging an index fund probably has a bit more slippage risk than hedging the Spiders.Hedging an ETF, mutual fund, or portfolio of stocks takes on anadded level of complexity when there are no options listed on theunderlying—whether they be cash-settled or not. The ﬁrst decisionan investor has to make is which option class best tracks a givenfund or portfolio.An investor who is long a small-cap mutual fund will probablywant to hedge it using the Russell 2000 Index options. One owningmostly mid-cap stocks will turn to the options on the Standard &Poor’s 600™ Index. For investors in large-cap stocks or large-capstock mutual funds, more choices is not necessarily synonymous witheasier choices: Standard & Poor’s 100 and 500 indices, the Dow JonesIndustrials, and a few other large-cap indices all have listed options.It also is possible to hedge portfolios or mutual funds that arefully or heavily weighted in one speciﬁc sector: investors will ﬁndoptions on the Dow Jones Transportation and Utility averages, theS&P Drug Index™, a couple of competing Nasdaq indices, and, insome instances, indices concocted by the options exchanges whennone were available, such as the PHLX Semiconductor Sector andthe CBOE Oil Index.An example will help us work through some of these issues. Aninvestor is holding an equity portfolio heavily weighted in technology stocks. She is looking to purchase some very short-term insurance on her holdings in front of some upcoming economic news.After studying the component stocks of the AMEX Computer Technology Index (XCI), the CBOE Technology Index (TXX), and thePHLX Semiconductor Sector (SOXSM) she concludes that the last onebest reﬂects her current holdings. (If you are wondering on whichsectors index options are listed, check the Directory of Exchange-
180
The Options Strategist
Traded Options at www.888options.com). Some of the 17-day optionslisted are:SOX:January 520 put:January 500 put:January 480 put:January 460 putJanuary 440 put:
534.36$14.60–$16.60$8.70–$10.20$4.90–$5.90$2.50–$3.50$1.25–$1.85
This investor’s portfolio is composed of various stocks in different quantities. How does she determine the number of puts to purchase? She should start with the value of the portfolio to be insured($175,000) and the level of the index (534.36). By multiplying the latter by 100 she gets the amount of underlying value covered by eachoption ($53,436). By dividing the value of her portfolio by the valuecovered by each option ($175,000 ⫼ $53,436) she gets the number ofoptions required to hedge her holdings: 3.27 options. Since she cannot purchase fractional options, she must decide whether to buyonly three puts and thus be partially unhedged, or to purchase fourand be slightly overhedged. Because of the relatively high cost of theput options (this is a very volatile sector), she decides to risk beingslightly underinsured and purchases only three puts, choosing the480 strike offered at $5.90. The cost of her hedge is therefore $1,770and will see her through the next two and one-half weeks. Table 7.4presents some of the possible outcomes, based on the assumptionthat her portfolio will rise and fall at the same rate as the SOX Index.Table 7.4
SOX LevelValue ofat Expiration 480 Put
Value of 3480 Puts
Cost of 3480 Puts
Value ofStockPortfolio
TotalPortfolioValue
560
$0
$0
($1,770)
$183,397
$181,627
520
$0
$0
($1,770)
$170,297
$168,527
480
$0
$0
($1,770)
$157,197
$155,427
440
$40
$12,000
($1,770)
$144,097
$154,327
400
$80
$24,000
($1,770)
$130,997
$153,227
Options on Exchange-Traded Funds and on Indices
181
Note that the protection offered is not complete because the portfolio is slightly underinsured. But the hedge does an excellent job ofstemming the losses once the puts go in-the-money. And, as noted,Table 7.4 is based on the assumption that if the SOX drops by 10%,so will the investor’s portfolio. This is a major assumption becauseeven indices that are highly correlated sometimes go their own way.Think of the DJIA and the S&P 500, two blue-chip indices that sometimes head in different directions. A hedge like this could experience severe slippage, which could work for or against our investor.Caveat emptor.A few words on hedging a mutual fund position: This is notunlike our previous example with an investor choosing an indexthat best ﬁts the fund’s holdings and having to accept the risk ofslippage. An additional problem with mutual funds is that theirmanagers have the right to change their holdings. So perhaps ahedge is established based on the funds holdings as of December31, but by the time the options expire the following March, somemajor shifts in sector weightings have occurred.Buying Index CollarsA full discussion of collars (buying a protective put and simultaneously writing a covered call on an equity you own) appears in thenext chapter, so you may want to look at what is to come before getting down to what is at hand.As far as purchasing collars on ETFs, we will consider these to beequity collars, and all of our comments in Chapter 8 stand. Thisassumes that there are options listed on the ETF in question and thatthese options are used to create the collar.The major issue we want to address in this section is purchasingcollars to hedge a basket of stocks, a mutual fund, or an ETF withno listed options. It sounds like a great idea. You own shares of anS&P 500 index fund and are looking for some short-term protection.Buying SPX puts is an excellent hedge, but there is a cost involved.Financing the purchase of these puts by writing calls gives you theshort-term protection you wanted with little or no cash outlay. Mission accomplished.Not quite. If you own a mutual fund and purchase puts to hedgethis position, your broker will not be concerned. When you buyputs, you have to pay the premium, and this represents your option
182
The Options Strategist
trading risk, end of story. But if you write an index call to ﬁnancethe purchase of the put, your broker will more than likely considerthe short call position to be uncovered and there the problems start.When purchasing an equity collar, the short call is covered: youown the underlying stock. When writing an S&P 500 call option (aspart of a collar) against an S&P 500 mutual fund, you are not considered to own the underlying. Remember that if the short call isassigned, you cannot deliver your mutual fund shares but mustmake a cash payment equal to the option’s in-the-money amount.In theory, the hedge is perfect: whatever losses you incur on yourshort call position will be fully offset by gains on the mutual fund.But, from an options trading and a margin perspective, your shortcall will be treated as uncovered.There are two downsides to this. First, you must get approvalfrom your broker to write uncovered index options. This is muchmore difﬁcult than getting approval for covered writing (needed tocreate a collar with equity options) and requires that you meet various tests in terms of account size and trading experience. (Rumorhas it one broker requires a DNA sample.) The second problem isone of margin and possible cash squeeze. If you have the authorization and write uncovered calls, you must margin this short position. In all likelihood your shares of the mutual fund will act ascollateral for this short call position. But if you are assigned on yourwritten call, you will have to make a cash payment to settle thisassignment. If the only assets you own are the shares of this mutualfund, you could ﬁnd yourself in a bind. Do you sell some of yourshares to meet your obligation, or borrow against your mutualfund? Either way, you are getting caught in a cash squeeze.If these are the problems created by hedging an S&P 500 mutualfund with short S&P 500 call options, think of the additionalheadaches created if you are trying to hedge a portfolio of stocksthat does not correlate perfectly to an index, or an ETF using optionson a “similar” index. You will have to deal not only with uncoveredoptions and a possible cash squeeze, but also with varying degreesof slippage as the underlying and the hedging instrument move inless-than-perfect harmony.In theory, a collar on a mutual fund or a basket of stocks soundslike a great idea. We could even show you numbers demonstratingthe beauty of the strategy. In real life it’s a completely different ket-
Options on Exchange-Traded Funds and on Indices
183
tle of ﬁsh, to be avoided by all but the most sophisticated (or foolhardy) investors.
Index Options: Trading StrategiesThe Continental DivideThe matter of selecting which index option class to trade based onexercise style, American or European, may appear of little importance. Not so if any written options are to be part of the picture.If you are only going to go long index options, we believe thereis little difference in whether you trade American- or European-styleoptions. You’ll go long, wait for the proﬁts to pile up, then sell yourposition. The notion of exercise will probably never enter yourmind.But if you are going to do any type of spreading, long one series,short another, we strongly suggest sticking to European-styleoptions. Think of the following equity option position: short the 60puts, long the 55 puts. If you are assigned early on the 60 puts, theoverall risk of the position will not change: the 60–55 put spread had$5 of risk. If you are forced to purchase the stock at $60 and are stilllong the 55 put, you still have $5 at risk, no matter what the price ofthe stock does after you have been assigned.Now think of the following index option spread, initiated withAmerican-style options: short the 600 puts, long the 550 puts. If youare assigned early on your 600 puts, you will not be obligated topurchase any securities, but will be forced instead to pay theoption’s in-the-money amount. So assume the underlying indexclosed yesterday at 540, and this morning your broker calls toinform you that you were assigned on your short 600 puts. Basedon yesterday’s close, the puts were $60 in-the-money and youraccount will be debited by that amount. You might think you couldcollapse your position by exercising your long put, but because theexercise and assignment process is done overnight, if you exerciseyour put today, the in-the-money amount you will receive upon theexercise of your long 550 puts will be determined by today’s closing index value. The market could rally strongly and your 550 putsbe out-of-the-money by day’s end. In fact, if today is the last trad-
184
The Options Strategist
ing day for these options, they could be worthless by the closingbell. You have therefore succeeded in losing $60 on a $50 spread!Since early assignments tend to occur relatively late in an option’slife, this example is not just a theoretical risk. Too many traders havelearned this lesson the expensive way. Stick with European-styleoptions and eliminate the risk of early assignment.Market RiskAn investor who purchases a stock assumes some risks. These aregenerally broken down into three levels:■
Market risk: Sometimes everything goes up or down together.Maybe the Federal Reserve Board has changed its interest ratetarget, or hinted that it is not about to change its target. Maybeconsumer conﬁdence is up, or maybe the price of oil is down.
■
Industry risk: Also known as sector risk. Sometimes a group ofstocks will rise or fall in tandem. Airline stocks might fall onhigher oil prices; ﬁnancial sector stocks might rise on loweredrates; or retail stocks might anticipate above-average Christmassales. Sectors will also react when a single company announcesan unexpected development. All chip stocks, for example, mightmove down when one chipmaker’s inventories are higher thanexpected.
■
Company risk: The market could be going up, with your stock’ssector leading the way, yet your stock might be down because itsbest-selling product is being recalled, or because there is a rumorthat the CFO has boarded a plane to Argentina using a one-wayticket, or because the proﬁts of this virtual company turned outto be virtual proﬁts.
Investing or trading in stocks means assuming all three levels ofrisk. Diversify (buy ﬁve bank stocks) and you can reduce companyrisk. Diversify more (in addition to your bank stocks, buy oil stocks,computer manufacturers’ stocks, health care providers’ stock, etc.)and you reduce sector risk. Diversify even more (buy all the stockson all the exchanges) and you still cannot reduce market risk. This
Options on Exchange-Traded Funds and on Indices
185
is one part of the risk spectrum that cannot be diversiﬁed away. Andthis is the realm of the index options trader.Buying Calls and PutsTo some, buying index options represents the ultimate trading experience: the individual and the market going one on one. This also isan area where the terms “short-term” and “long-term” take on completely different meanings. Some traders refer to long-term positions as anything they hold more than one hour.Take a trader who is looking to purchase call options on the Standard & Poor’s 100 Index (OEX) and who does not intend to holdthese options any longer than a day. The issue of time decay is virtually eliminated, especially if he plans to day trade. He must stilldecide which strike price to purchase and, looking at the frontmonth options, which have 24 days until expiration, he ﬁnds the following listed for trading.OEX:530 call:540 call:550 call:560 call:570 call:
549.48$24.40$16.45$10.20$5.65$2.80
⫹0.75⫹0.65⫹0.50⫹0.35⫹0.21
The prices given are the midpoints between the bid and the ask,and the second number is the options’ delta. Our trader calculates,as a ﬁrst approximation, what his return would be on each optionif the OEX rose one point. This is simply the expected gain, i.e., theoption’s delta, divided by the cost of the option. The results obtainedare as follows:530 call:540 call:550 call:560 call:570 call:
⫹3.1%⫹4.0%⫹4.9%⫹6.2%⫹7.5%
186
The Options Strategist
This ﬁrst approximation appears to favor the out-of-the-moneyoptions. But the above returns ignore one important fact of real-lifetrading: the options’ bid-ask spread. If the expected proﬁt is reducedby $0.1