Index options trading is much more risky than Etf and index mutual funds and we don't recommend it for anyone. First let's explain a bit what is options trading. The most popular index options on market are the OEX which applies to SP100 and the SPX which applies to SP500 index. There is one for the NASDAQ, the NDX, but it is not used a lot and we don't recommend using it at all.
Option trading is more complex than trading stocks or mutual funds. When we trade an option we have to specify a strike price, an expiration month, which type of option trading you want (CALL or PUT) and on which side your initial position will be.
Let's first discuss the strike price. For each index option we discussed (OEX and SPX) we have a strike price at every 5 points. For example if the SP500 index is at 1402 you then have the choice to take 1400 or 1405 strike price. You could also use 1395 or 1410 if you want. The difference with each strike price is the premium. If we take our example and you decide to buy an index option with 1400 strike price when the market is at 1402 you would pay about $4,000 with the SPX and about $2,000 with the OEX depending on how much days remains before the option expires. If you would choose 1405 instead your option would cost a bit less for a CALL.
Let's now discuss the index option expiration month. An index option expires every third Friday of each month. So the maximum time it can last is about 5 weeks. At the beginning the premium is high and declines as we get towards the expiration. This is a very important factor to consider if you choose to use this type of trading tool. It forces you to take a very short term approach instead of a more mid term approach that our index trading system is teaching. When an index option expires it is worthless.
Let's now discuss the type of index option you can choose. If you decide to trade the market on the UP side you would pick a CALL. If on the other hand you would want to play the market on the DOWN side you would pick a PUT. So yes you can bet on a market decline to make money if you have the nerves to do so.
Let's now discuss the initial position side. When we initiate a trade with an index option we can buy an option from someone or we can sell an option to someone. There is a big difference between the two. If you buy an option from someone else your risk is limited to the price you paid, you cannot lose more than that and your profit potential is unlimited. On the other hand if you sell an option to someone else as the opening position your loss potential is unlimited and your profit is limited to the price you received on the transaction. This is what we call a naked PUT. It also takes quite a bit of margin to initiate a naked PUT (Between 10000 - 15000 for SPX index option). So if you are betting on the market to go up, you can buy a CALL or sell a PUT.
Let's go through some examples. Let's say the SP100 index is trading at 782 on July 26th 2000 and we decide to play the market up. So here we are at more than 3 weeks from the expiration in august. We can decide to buy a CALL with strike price 780 and pay approximately $2,000. If the market moves to 795 in the next week our OEX index option would be valued at about $2800. If it was 2 weeks after the buy at the same level (795) the value would probably be at $2500. So as you can see the time in this case plays against you regarding the premium.
Let's now say that SP500 is trading at 1400 on August 2nd, 2000 and we decide to trade the market up. So we are at less than 3 weeks from expiration. We also decide to sell a PUT at 1400 and collect around $3,000. If the market moves up without coming back and the option expires the money is yours forever. If the market goes down to let's say 1385 on august 11th (one week before expiration) your put option worth now about $4,000 and you could be facing a $1,000 loss if you should decide to close your position at this time. However if you hold your option until the expiration time and the market did not fall under 1370 you would not lose any money. Remember that if you sell a PUT, we must have an important margin in cash or securities in your account. The margin fees vary from firm to firm.
As you can see index option trading is complicated and the risks are much higher. You can lose all the money your putting at risk or you can double even triple your money in a few months only. Even if it could be used with our index trading system we don't recommend using this investment vehicle. It takes a lot of self control and the capacity to stay cool when the market turns against you temporally. If you are a nervous person don't even consider using this option trading, even if it is very attractive. If you don't have much money to invest, please don't use index options and use either mutual funds or exchange traded funds. Of course the leverage gain is high using index options and only very advised and cool investors should use those instruments. For very advised and experimented traders, index options can be used under high oversold conditions like the one we describe in the page
special oversold opportunities.
This option trading opportunity is a perfect one.
So we hope you learned the ropes with index option trading. Of course much more complicated option strategy can be used and for that we recommend you see our
Option trading system page for alternatives to index options trading.
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