.
For example, let’s say IBM is trading at $105 a share. The S&P500 might be trading at $1,450 a share. That would be $1,450 times250. (When the S&P Index contract was launched, the multiplier forthe value of the overall S&P contract was 500. About two years ago,the size of the S&P contract was cut in half, reducing the multiplierto 250.) That means that a single contract for the S&P 500 wouldrepresent an underlying value of $1,450 times 250, or $362,500. Bythe same token, at $105 a share, a single contract trade in IBMwould represent an underlying value of $105 times 100, or $10,500.
That difference—$362,500 for one S&P contract versus about$10,000 for one equity contract—underscores the need for contra-party credit risk protection for index options trading—the size gets112 how I trade options
500. Goldman Sachs would quote a price at which it would buy thefuture price of the S&P 500 if the customer were selling, or the priceit would sell the future price of the S&P 500 if the customer werebuying. A transaction would be conducted which was off-exchangeor over-the-counter.
But that kind of transaction, which still takes place in certaincustomized options and other off-the-exchange products, presenteda large risk, known as contra-party risk. That means, by doing anover-the-counter trade, you have to bear the full credit risk of theperson or party with whom you traded. Thus, if that other partyhad other obligations that caused losses, it might not be able to ful-fill the obligation to you under terms of the trade you made. Like-wise, that other party had to deal with your potential credit risks,in case the situation arose that you could not financially fulfill yourobligations.
This credit risk posed by party-to-party, over-the-countertrades and the sheer size of the market for index options were thecatalysts that prompted the creation of options exchanges in thefirst place. Before the exchanges were created, options on individ-ual stocks had traded over-the-counter for years. Likewise, the cat-alyst for index options was partially the burgeoning OTC trading ofindex options, as well as the initial success of the index futures con-tracts listed first by the Kansas City Board of Trade, which broughtout the Value Line Index and the Chicago Mercantile Exchange’ssubsequent listing of the S&P 500 futures contract. Since indexesare generally made up of anywhere from 10 to 1,000 stocks, over-the-counter trading of these options dwarfed the dollar-value—and,therefore, the potential risk—of equity options trading.
For example, let’s say IBM is trading at $105 a share. The S&P500 might be trading at $1,450 a share. That would be $1,450 times250. (When the S&P Index contract was launched, the multiplier forthe value of the overall S&P contract was 500. About two years ago,the size of the S&P contract was cut in half, reducing the multiplierto 250.) That means that a single contract for the S&P 500 wouldrepresent an underlying value of $1,450 times 250, or $362,500. Bythe same token, at $105 a share, a single contract trade in IBMwould represent an underlying value of $105 times 100, or $10,500.
That difference—$362,500 for one S&P contract versus about$10,000 for one equity contract—underscores the need for contra-party credit risk protection for index options trading—the size getsplaying the broad market 113
pretty scary really fast. The need for protection from contra partyrisk was one of the reasons to list index options and the other wasthe oft-forgotten individual investor. The OTC index option marketleft the retail investor out in the cold, as virtually no retail cus-tomer was on the radar screens of the investment banks and trad-ing houses that made markets in the OTC index options. The earlysuccesses and relative contract size of both the KC Value Line fu-ture and S&P 500 future at the CME indicated the retail investorwas willing to invest in index futures. And if they were willing totrade futures, it was only a matter of time before index options tookhold as well.
The institutions that called Goldman Sachs or any other majorbrokerage house to find a market in index options (in the days be-fore they were listed on an exchange) were looking to offset port-folio risk. In other words, they were looking to protect the value oftheir stock portfolios and to obtain some downside “insurance”through the use of other financial instruments such as futuresand options.
Thus, if they thought the market was going sideways or was indanger of declining, they would look to sell futures on the indexes.This way, the profit they’d made on the futures would partially orfully offset losses suffered in the stocks, themselves. (Conversely, ifthe market did rise, gains in the stock portfolio would offset losseson the futures.) But without listed derivative securities (as futuresand options are considered since their value is derived from the un-derlying cash market) a customer could be at the mercy of whoeverwas quoting the market. In other words, if a customer with a largestock portfolio called to find out the market in S&P index optionstrading over-the-counter, it was a pretty good bet that customerwas looking to buy puts or sell calls to guard against downside pro-tection. Knowing that, the trading firm could conceivably quote aprice that would guarantee the house a favorable deal at the ex-pense of the customer. And since these options weren’t listed byany exchange before 1983, there was no easy access to bids and of-fers. The only way would be to make dozens of phone calls to indi-vidual brokers and financial institutions who were willing to quoteyou a price and take on the contra-party risk.
In an open outcry, pit-trading environment, there is a constantstream of competitive bids and offers, consolidated in one place.From the customer’s perspective, this is a huge improvement.114 how I trade options
Open outcry provides instantaneous access to numerous bids andoffers, all at competitive prices—without wearing out the speeddial on the phone to call a dozen brokerage houses for quotes.
Those competing, continuously quoted markets were whythe OEX (options based on the CBOE’s 100 stock index) quicklybecame popular with retail and institutional players. And asstated previously, the OEX is one of the few American-style indexoptions that can. be exercised at any time. SPX options, which areEuropean-style, can only be exercised at expiration and are thus,even more popular with institutional users, who usually want toput on positions for portfolio insurance and not worry that the op-tion would be exercised until expiration. On the other hand, sinceEuropean-style options can’t be exercised in the interim, thecost of holding the position has to be factored into the overallvalue. Thus, there’s no way the options can trade at parity. For ex-ample, if the S&P index is trading at $1,450 a share, the $1,400calls would normally have $50 worth of intrinsic value (the differ-ence between the strike price and the market). But in reality, thecost of carrying the position until expiration would reduce thevalue of a $50 option, which, at 8 percent interest, might cost you$1 for 90 days, to $49, reflecting a $1 discount from its intrinsicvalue ($50 x 8% x 90 / 360 = 1) . And the further out the time (andtherefore the longer the carrying value), the greater the discountto the intrinsic value.
The OEX, however, is an index option of a different flavor.Made to appeal to retail investors, and not just the hedgers whowere trading over-the-counter products, the OEX is American-style,meaning it can be exercised at any time at the buyer’s discretion.As retail customers quickly found out, the OEX allowed them toparticipate in the broader market and thus avoid the “right church,wrong pew” syndrome. As most active equity investors have expe-rienced at one time or another, the overall market can be upstrongly, but some individual equities will make a contrary move tothe downside. On those days, you indeed feel like you're in the rightchurch, but you've definitely sat in the wrong pew.
Trading an index, on the other hand, gives you exposure to nu-merous stocks; in the case of the OEX, you can trade the value of 100of the biggest stocks as one unit. This is not only a cost effective wayto gain this exposure (as opposed to trying to buy and sell optionson 100 different equities), it also gives you instant diversification114 how I trade options
Open outcry provides instantaneous access to numerous bids andoffers, all at competitive prices—without wearing out the speeddial on the phone to call a dozen brokerage houses for quotes.
Those competing, continuously quoted markets were whythe OEX (options based on the CBOE’s 100 stock index) quicklybecame popular with retail and institutional players. And asstated previously, the OEX is one of the few American-style indexoptions that can be exercised at any time. SPX options, which areEuropean-style, can only be exercised at expiration and are thus,even more popular with institutional users, who usually want toput on positions for portfolio insurance and not worry that the op-tion would be exercised until expiration. On the other hand, sinceEuropean-style options can’t be exercised in the interim, thecost of holding the position has to be factored into the overallvalue. Thus, there’s no way the options can trade at parity. For ex-ample, if the S&P index is trading at $1,450 a share, the $1,400calls would normally have $50 worth of intrinsic value (the differ-ence between the strike price and the market). But in reality, thecost of carrying the position until expiration would reduce thevalue of a $50 option, which, at 8 percent interest, might cost you$1 for 90 days, to $49, reflecting a $1 discount from its intrinsicvalue ($50 x 8% x 90 / 360 = 1) . And the further out the time (andtherefore the longer the carrying value), the greater the discountto the intrinsic value.
The OEX, however, is an index option of a different flavor.Made to appeal to retail investors, and not just the hedgers whowere trading over-the-counter products, the OEX is American-style,meaning it can be exercised at any time at the buyer’s discretion.As retail customers quickly found out, the OEX allowed them toparticipate in the broader market and thus avoid the “right church,wrong pew” syndrome. As most active equity investors have expe-rienced at one time or another, the overall market can be upstrongly, but some individual equities will make a contrary move tothe downside. On those days, you indeed feel like you’re in the rightchurch, but you’ve definitely sat in the wrong pew.
Trading an index, on the other hand, gives you exposure to nu-merous stocks; in the case of the OEX, you can trade the value of 100of the biggest stocks as one unit. This is not only a cost effective wayto gain this exposure (as opposed to trying to buy and sell optionson 100 different equities), it also gives you instant diversification114 how I trade options
Open outcry provides instantaneous access to numerous bids andoffers, all at competitive prices—without wearing out the speeddial on the phone to call a dozen brokerage houses for quotes.
Those competing, continuously quoted markets were whythe OEX (options based on the CBOE’s 100 stock index) quicklybecame popular with retail and institutional players. And asstated previously, the OEX is one of the few American-style indexoptions that can. be exercised at any time. SPX options, which areEuropean-style, can only be exercised at expiration and are thus,even more popular with institutional users, who usually want toput on positions for portfolio insurance and not worry that the op-tion would be exercised until expiration. On the other hand, sinceEuropean-style options can’t be exercised in the interim, thecost of holding the position has to be factored into the overallvalue. Thus, there’s no way the options can trade at parity. For ex-ample, if the S&P index is trading at $1,450 a share, the $1,400calls would normally have $50 worth of intrinsic value (the differ-ence between the strike price and the market). But in reality, thecost of carrying the position until expiration would reduce thevalue of a $50 option, which, at 8 percent interest, might cost you$1 for 90 days, to $49, reflecting a $1 discount from its intrinsicvalue ($50 x 8% x 90 / 360 = 1) . And the further out the time (andtherefore the longer the carrying value), the greater the discountto the intrinsic value.
The OEX, however, is an index option of a different flavor.Made to appeal to retail investors, and not just the hedgers whowere trading over-the-counter products, the OEX is American-style,meaning it can be exercised at any time at the buyer’s discretion.As retail customers quickly found out, the OEX allowed them toparticipate in the broader market and thus avoid the “right church,wrong pew” syndrome. As most active equity investors have expe-rienced at one time or another, the overall market can be upstrongly, but some individual equities will make a contrary move tothe downside. On those days, you indeed feel like you’re in the rightchurch, but you've definitely sat in the wrong pew.
Trading an index, on the other hand, gives you exposure to nu-merous stocks; in the case of the OEX, you can trade the value of 100of the biggest stocks as one unit. This is not only a cost effective wayto gain this exposure (as opposed to trying to buy and sell optionson 100 different equities), it also gives you instant diversificationplaying the broad market 115
across several industry sectors. Trading the OEX, you’re going tohave exposure to the top financial stocks such as Merck (MRK) andCitiGroup (C); the top industrial shares Alcoa Inc. (AA), Boeing Co.(BA), or United Technologies (UTX); the top oil stocks such asExxon (XOM); networking stocks such as Nortel Networks (NT)and Lucent Technologies (LU); chipmakers such as Micron Tech-nology (MU) and Motorola (MOT); and so on for American-style op-tions. And since American-style index options give the buyer theright to turn their call or put options into cash at each evening’ssettlement price, they carry their premiums virtually all the wayuntil expiration, rather than trading at a discount to intrinsic valuelike their European cousins.
Going back to our example, let’s say you own a $750 OEXcall, and now the OEX is trading for $780 per share. Since it’s anAmerican-style option that may be exercised any time at thebuyer's discretion, it has $30 a share in intrinsic value. Moreover,it would probably be trading for a premium above its intrinsicvalue, putting the price at $30.50 to $31 a share. If that OEX,American-style option did trade at a discount, you could simplybuy that option and exercise it for cash (remember, equity-indexoptions settle for cash, not the basket of stocks that underliethem), thus capturing the difference between the intrinsic valueand the discounted price that you paid them. For this reason,American-style index products are not for everybody—especiallylarge institutions that like to sell options against their portfoliosand hold that insurance until expiration. They don’t want to findthemselves cashed out at a time when the option trades belowparity before expiration.
early exercise
For American-style options, one of the most common times for thiscashing out (technically known as an early exercise) is during the15-minute window between the close of stock trading at 4 p.m. East-ern time and the time when index futures stop trading, which is4:15 p.m. Eastern time.
Let’s say an institution had sold 500 OEX call options severalweeks before, and those options were trading slightly above paritygoing into the close. This would probably lead the institution tothink its hedged position is relatively secure. But now let’s say the116 how I trade options
stock index futures start dropping after the stocks stop trading.Maybe some key stock declared less than expected earnings andthe S&P futures started freefalling. The customers (institutional orregular retail investors) who purchased those OEX options couldexercise them for the closing cash value of the index—and buythe discounted futures to replace the exercised long position in themarket. That would place the call option buyer back in the same po-sition since they’ve simply replaced the long in-the-money call witha long position in the futures, which they purchased on the after-hours dip at a lower, more favorable price. The net effect is, they’vetaken the institution out of its short position by exercising theseoptions. The institution is cashed-out of its short options on theclosing price, despite the fact that the future is now trading at a sig-nificant discount to the cash value.
The same could occur on the short put side of the early exer-cise predicament. For instance, you could be short the 810 puts inan American-style index like the OEX, trading at $780. Those putsare $30 in-the-money. (Remember, a deep in-the-money short putmakes the seller money when the market trades higher and losesthe seller money when the market trades lower. The customer thatsold these puts may have sold them as a bet the market would tradehigher, or as a hedge against a short position in the market.) If theOEX cash closed at $780 at 4:00 p.m. and then the S&P 500 futuresbegan to run to the upside after the cash closed, those short putscould come back and bite you. Here’s how: the cash value of thoseputs is pegged at $30 (810 strike price minus $780—the closingprice at 4:00 p.m.). If the futures began to run after the cash closes,the owner of those puts might infer that the market will openhigher tomorrow and thus, his or her put would be worth less thanthe $30 they are trading for tonight. Therefore, the put owner mightexercise the put for the cash value ($30 in this example) and eitherreplace their short position in the market by selling the rallying fu-tures contract, selling a call which should be rallying along with thefutures, or buy a replacement put at a cheaper price.
If you’re an institution wanting to hedge your portfolio, that’snot the kind of scenario you want to face suddenly. For that reason,the institutions favor the S&P 500 and other European-style indexoptions—not so much for speculation but for insurance.
The same goes for a customer. You don’t have to be an institu-tion to get hurt by this arbitrage, or the difference between theplaying the broad market 117
index options value and that of the underlying cash or futures mar-ket. If you were a customer who has sold five OEX index options asa hedge against your mutual fund holdings, you’d face a similar sit-uation if there were a sell-off in the futures market between theclose of the stock market and the end of the futures session. Youcould very well come in the next day to discover that you’re with-out your short index calls because the buyer exercised them. You’dbe long your mutual fund holdings, without a hedge, and youwould have bought back your short index calls the night before at ahigher price.
Yet, index options, when used in conjunction with an invest-ment strategy (remember, you never want to sell a naked option—on an index or an individual stock—without some offsetting factorto reduce risk) can allow you to play the broader market. The exactstrategies that can be employed in stocks (as discussed in previouschapters) can also be used in an index.
One important thing to keep in mind, however, is that an indextends to smooth the volatility of the component stocks, the sameway that a mutual fund gives the diversity of many stocks. This di-versity tends to flatten out the peaks and valleys of the volatility ofthe stocks in the index. This is why the OEX, which contains multi-ple sectors, has a smoothed volatility that normally trades in arange from 18 percent to 36 percent, although its components col-lectively probably average twice that.
If you look at a volatile sector like biotechnology or Internet,the stocks that make up that index might average 100 percentvolatility. However, differing from the OEX, or SPX which containmultiple sectors, a single sector index will smooth the volatility, butnot nearly so much as an index that can spread risk over a wider va-riety of stocks.
One indicator looked at by many people is the range of volatil-ity for the index. The CBOE expresses this as the VIX—the VolatilityIndex. When the VIX is at its zenith, many of us are active sellers ofindex premium (Figure 6.1). When it’s at its low point, we tend tobuy index premium because the odds favor the buyer on the low endand the seller on the high end. Also, historically, low ebbs in volatil-ity for the index have signaled a rapid movement forthcoming.
Options, like most commodities, are driven by supply and de-mand. When there is extremely large supply, they are cheaper.When they are in demand, the supply dries up and they are more 
118 how I trade options
 
Figure 6.1 VIX weekly
 
| iExchange provides |» no volumd data. t: | :
 
Source: BigCharts.com.
expensive. In the case of index options—which do not reflect a sin-gle stock but rather marketwide (or at least sectorwide) action—you can watch this market movement to help your trading.
Here’s an example: When volatility (which, as you recall, is agauge of risk) gets extremely low, I know the buyers of portfolioprotection have not stepped into this market. That tells me the pro-fessionals and others in this market could be getting a little toocomfortable, and very few people have come to the options marketfor protection. Perhaps instead of buying puts to protect against afall in the price of shares they own, they have simply elected to sellcalls. Thus we might see an oversupply of call sellers and, there-fore, premiums are cheap. That’s usually an opportunity for buyerssince, in my mind, the market rarely makes an extraordinary movewithout some sort of short-supply or buying panic. So when theworld, that has become overconfident, suddenly perceives a needfor protection, the price and market volatility suddenly skyrocket.And if you’ve bought just before that panic materializes, you maybe in for a nice market ride.
Conversely, when the VIX is on the high end, it reflects thedemand from everyone who panicked and sought out protectionplaying the broad market 119
from options. The buying frenzy pushes premiums for puts andcalls higher as volatility increases. It’s unlikely that this sort ofpanic-triggered accumulation will hold for a long period of time. Re-member, with index options such as the OEX, the focus in on a bas-ket of the largest capitalized stocks, as well as overall marketsentiment. It’s not dependent on an earnings announcement orFood & Drug Administration (FDA) approval for a company’s newmedical device. In an individual equity, there are considerable risksin selling premium, because you could face short squeezes, stockbuybacks, or takeovers.
In indexes, there can’t be any takeovers or short-squeezes.Even if one or two stocks in an index have an extraordinary event—like a takeover or a stock buyback—the overall basket of issuesresults in a smoothing effect. Put another way, Microsoft could de-cide to buy back 100 million shares of its stock, which would un-doubtedly send the price of its shares soaring. But what would bethe net effect on the other 99 stocks in the OEX? Most likely, itwould be negligible, in particular because the MSFT move was anisolated event.
Another advantage of premium selling in index options is thatthere are usually many strikes above and below the market. So ifyou are a person who is comfortable with selling premium (under-standing the risks and devising an offsetting strategy), you can picka wide range in which your strategy will work and you can makemoney. This is a far better deal than the relatively narrow range ofstrike prices for an individual equity.
If I was looking for Dell and Cisco to make a breakout move andOEX volatility was low, perhaps I would use that information as onemore factor that could help fuel a rally, as the lack of buyers may in-dicate premium levels could move quickly higher, benefiting the op-tion buyer.
To find out more about the VIX and to get daily updates, go tothe CBOE Web site (www.CBOE.com). The site displays a table thatincludes the current quote; net change; 52-week high and low; andthe open, high, and low quotes.
Whether or not you choose to trade index options, considerthese instruments—such as the VIX—to be one more tool in thetoolbox to help you construct a profitable trade.
Now, consider spread trades, as discussed in previous chap-ters. When the range of strike prices is narrow, we have fewer120 how I trade options
strategies that we can effectively employ. This is rarely the case inindex options, which normally have numerous strikes above andbelow the cash value of the index.
One example is the iron butterfly, with a body formed by astraddle trade, and wings that limit the upside and downside risk:This is one of the most popular spreads for selling premium withlimited risk. Now, let’s see how this trade would work with OEXoptions.
Let’s say the OEX is trading at $850 a share. You might sell the$880 calls and sell the $820 puts. To protect the upside, you mightbuy the $885 calls and, similarly, you’d buy the $815 puts to insurethe downside. Your maximum risk would then be the difference be-tween each spread. We’ve basically sold a $5 call spread on the up-side, and a $5 put spread on the downside. Our maximum exposureon both sides would be $5.00. Now let’s say we only took in $1.75 inpremiums. Our maximum risk would be the $5 spread minus thepremium received, or $3.25.
Now that risk/reward ratio would probably not be attractivefor an option on an individual equity. But in this instance, it mightbe a reasonable investment for the opportunity to profit over areasonably wide range to the upside and the downside of thebroader market. And since we're investing in an index option, weknow that the risk is spread over a broad basket of stocks, whichsmoothes out the volatility and the price movement. That’s whatmakes this strategy attractive. For example, in the 1990s and early2000, it has been common to see sector rotation. If Wall Streetlikes e-commerce stocks, those shares go up, and dollars getpulled out of other sectors like drug stocks. These rotations meanthat the broad market might only advance by a small percent-age—which is great if you are playing a spread trade on thebroader market.
The above strategy works in both the SPX (based on the S&P500 cash market) and the OEX (based on the top 100 stocks on theCBOE). But most customers will choose the OEX because they cancollect more premium in that index because it’s American-style.
But there are far more indexes than just the OEX and theSPX—such as the Philadelphia Semi-Conductor Index (SOX) andNasdaq 100 Index (QQQ). Plus, there are spiders, a kind of hybrid se-curitized equity that trades like a stock but is actually a depositoryplaying the broad market 121
receipt that trades at a fractional value of the S&P 500. Here’s howspiders work: First, State Street Bank, which underwrites the spi-ders, buys all 500 stocks in the S&P 500 and deposits them into atrust. (In return for overseeing this S&P 500 Depository Receipt—which is how spiders are officially known—State Street Bankreceives about 18 basis points in management fees. State StreetBank also collects interest on the dividends paid on the basket ofstocks before the payouts are sent at the end of the quarter to thespider holders.)
State Street then issues shares, known as the spiders (AMEXsymbol: SPY), that trade on the American Stock Exchange and trackthe dollar-for-dollar performance of the S&P 500. What makes spi-ders convenient is that they have one-tenth the value of the S&P,making it a more reasonable investment for retail investors. As ofthis writing, the S&P 500 is trading at 1450, so a %o value SPY tradesfor $145 per share. A great feature of spiders is that unlike normalstocks which represent corporate equity, you don’t need an uptickto short shares. Additionally, these little beauties trade in incre-ments as small as %«th and trade multimillion shares per day, mak-ing them one of the most liquid securities in the world. Due to thesuccess of spiders, the AMEX has listed depository receipts on theDow Jones Industrial Average (DIA) and the Nasdaq (QQQ).
In our proprietary trading firm, PTI Capital Management LLC,a strategy that we might use for clients is basically an insuredindex portfolio using the spiders.
Here’s how we’d make the trade: We buy 1,000 shares of SPY.Then we buy one long-term or LEAP put option on the S&P (we onlypurchase one LEAP put because unlike the SPY, which trades Xo thevalue of the S&P 500, the LEAP represents 100 shares of the fullvalue S&P). Finally, we sell one out-of-the-money short-term callagainst this position. A simple way to explain this is, we havebought the SPY to speculate on the upside, and we have downsideprotection by virtue of our purchase of a long-term put. We financethat long-term put by selling a short-term call. We normally sell acall that is 5 percent to 7 percent out-the-money, so althoughthe upside is capped by the call sale, we participate fully up tothat level.
Since July 1997, this strategy has successfully tracked the per-formance of the S&P 500 within 6 percent, but with less volatility 
 
 
 
122 how I trade options
and less downside risk. We also use this strategy for the QQQ andthe Dow Jones 30 (Diamonds).
Many customers who come to us for this strategy are invest-ing fresh money in the market. But, because the market is sovolatile, they’re not comfortable just buying it. Rather, they wantsome protection in case the market turns out to be driven to itslofty heights by the “greater fool theory”: Every fool who buys fromthe next fool at a higher price becomes the greatest fool, until there