Basic Strategy

The flexibility of index options comes from the wide variety of strategies available to investors. The following examples explain the most basic uses of index options. These examples are based on hypothetical situations and should only be used as examples of possible trading methods. Other strategies that can be used with common stock options, such as straddles and saddles, can also be used with index options. For a more detailed explanation, contact your brokerage firm or exchange that trades index options.

Note: For the sake of illustration, these examples ignore commissions and transaction costs, tax considerations, and costs in a margin account. These factors can affect the possible outcomes of a strategy. Therefore, consult with your brokerage firm and tax advisor before using any of these strategies. For the sake of illustration, all of these index option positions in these examples are held to expiration. The amount of premium is assumed to be appropriate. In reality, however, similar options may not have such premiums on or before expiration.

Strategy 1: Buying Index Call Options

Market outlook: short-term bullish

Objective: To position yourself to benefit from increases in the value of the underlying index.

You expect the stock market, or a sector of the market as measured by an underlying index, to rise in the near term. You want to take a very risky position that provides a lot of leverage. Before making this decision, you know that you could potentially lose all of the premium you paid for this option.

Index call options give the buyer the opportunity to participate in the underlying index moving above a pre-determined strike price before the option expires. The buyer of an index call option has unlimited potential profit. This profit is related to the strength of the underlying index’s rise.

situation

Assume that the symbol of the underlying index you are interested in is XYZ and its current value is 200. You decide to purchase a 6-month XYZ 205 call option at a quoted price of $4.75 per contract. Your net outlay for this option is $475 ($4.75 multiplied by 100). When the XYZ call option expires, if the underlying index is not above the strike price of 205, your risk is $475. The breakeven point at expiration is when the XYZ index is at 209.75 (strike price 205 + premium paid of $4.75) because the call option has an intrinsic value of $4.75, which is the price you initially paid. The higher the settlement value of the XYZ index is above the breakeven point on the expiration date, the greater your profit.

Possible outcomes at expiration date

1. The index value of XYZ is above the break-even point (209.75):

At expiration, if the XYZ Index rises to 215, the XYZ 205 call option will have an intrinsic value of $10 (settlement value 215 – strike price 205). In this case, your net profit is $525 (settlement amount from exercise $1,000 – net cost of the call option $475).

Buy XYZ Index 205 Call at $4.75 when the index is at 200. Net cost of the call = $475

XYZ Index value at expiration date	XYZ Index falls to 198 (below the strike price)	XYZ Index rises to 207 (between the strike price and the breakeven point)	XYZ Index rises to 215 (above breakeven)
Movement of index value	Down 2 points.	Up 7 points.	Up 15 points.
Call option value at expiration (per contract)	0 (Elimination)	$2	$10
Minus the premium paid for the call option	$4.75	$4.75	$4.75
Net Profit/Loss* (per contract*100)	-475 USD	-275 USD	$525

*Excludes commissions, transaction costs and taxes.

2. The XYZ index value is between the strike price (205) and the breakeven point (209.75):

At expiration, if the XYZ Index rises to 207, then the XYZ 205 call option will have an intrinsic value of $2 (settlement value 207 – strike price 205). You can exercise the option and receive a settlement quantity of $200 ($2 intrinsic value multiplied by 100). This amount is less than the amount paid for the call option ($475), but will offset some of the cost. The net loss in this case would be $275 ($475 net cost paid for the call option – $200 settlement quantity received from exercise). This loss is slightly more than half of your initial investment.

**3. XYZ Index falls below the strike price (205): ** At expiration, if XYZ Index falls to 198, the call option is worthless because it is out-of-the-money. You will lose your entire initial investment, a net loss of $475. The maximum loss for the option buyer is the net premium for purchasing the index option. Note: No matter how far XYZ falls below the strike price, the loss will not exceed $475.

Strategy 2: Buying Index Put Options

Market outlook: short-term bearish

Goal: To open a position to profit from a decline in the underlying index value

You expect the broad stock market or a market sector as measured by an underlying index to decline in the near term. You want to take a very risky position that provides a lot of leverage.

Before making this decision, you know that you could potentially lose the entire premium you paid for the option.

Index put options give the buyer the opportunity to participate in the potential for the underlying index to fall below a predetermined strike price before the option expires. The buyer of an index put option has a huge potential profit. This profit is related to the strength of the decline in the underlying index.

situation

Assume that the symbol of the underlying index you are interested in is XYZ and its current value is 200. You decide to purchase a 6-month XYZ 195 put option at a quoted price of $3.90 per contract. Your net cost for this put option is $390 ($3.90 multiplied by 100). At the expiration of the XYZ put option, if the underlying index value is not below the strike price of 195, then your risk is $390. The breakeven point at expiration is when the XYZ index value is 191.10 (strike price 195 – $3.90 paid). This is because at this point, the put option has an intrinsic value of $3.90, which is your initial payment. The lower the XYZ index settles below the breakeven point at expiration, the greater your profit.

Possible outcomes at expiration date

1. The XYZ index value is below the break-even point (191.10):

At expiration, if the XYZ index is as low as 185, the XYZ 195 put option will have an intrinsic value of $10 (strike price 195 – settlement value 185). In this case, your net profit will be $610 (settlement amount from exercise $1000 – net cost of the put option $390).

2. The XYZ index value is between the strike price (195) and the breakeven point (191.10):

At expiration, if the XYZ Index falls to 193, the XYZ 195 put option will have an intrinsic value of $2 (strike price 195 – settlement value 193). You can exercise the option and receive a settlement amount of $200 ($2 intrinsic value multiplied by 100). This amount is less than the net amount paid for the put option ($390), but it offsets part of the cost. The net loss in this case is $190 (net cost of the put option – settlement amount of $200 received from exercise). This loss is slightly less than half of your initial investment.

3. XYZ Index Value is Above the Strike Price (195): On the expiration date, if XYZ Index rises to 202, the put option will be worthless because it is out-of-the-money. You will lose your entire initial investment of $390. The net premium paid for an index option is the maximum loss for the option buyer.

Note: No matter how far XYZ moves beyond the strike price, the loss will never exceed $390.

Buy XYZ Index 195 Put for $3.90 when the index is at 200. Net cost of the put = $390

XYZ Index value at expiration date	XYZ Index rises to 202 (above the strike price)	XYZ Index falls to 193 (between the strike price and the breakeven point)	XYZ Index falls to 185 (below breakeven)
Movement of index value	Up 2 points.	Down 7 points.	Down 15 points.
Put option value at expiration (per contract)	0 (Elimination)	$2	$10
Minus the premium paid for the put option	$3.90	$3.90	$3.90
Net Profit/Loss* (per contract*100)	-$390	-$190	USD 610

*Excludes commissions, transaction costs and taxes.