You’re probably familiar with index funds, mutual funds that track a particular stock market index such as the Dow Jones Industrials or the Standard & Poor’s 500. More adventurous investors use stock index options to protect their portfolios against stock market corrections.
Stock index options are agreements pegged to the performance of the underlying index. These might be call options, the right to buy the index, or put options, the right to sell the index. Both types of options may be bought or sold and exercised at a given price up to a certain date. However, because the average price is $30,000-too large a sum for individual investors-these options are rarely exercised, but they are traded.
Why would you want to master such concepts? Because of the chance to earn bigger profits, even though the broad stock market is making modest moves. To see how this might work, here’s an example involving options known as OEX, which cover the S&P 100 Index of giant companies. “The OEX is the stock index option most actively traded among individual investors,” says Stanley Marszalk, vice president of CMI Business Services Inc. in Destin, Florida, which publishes The Index Options Trader ($95 for six weeks; www.theoptiontrader.com).
Recently, the S&P 100 Index was hovering around 780 index level. At that index level, each OEX option covered $78,000 (780 times $100) worth of stock. Yet options to buy the index at 780, with expiration in one month, were listed around $1,900. (The newspaper listing was 19, but you multiply that by $100 to get the price.)
If the stock index goes up, so will your option. “Suppose the index is trading at 820 at expiration date,” says Bill Ryan, a manager of the options industry services call center at the Options Clearing Corp., a financial derivatives clearinghouse in Chicago. “You have the option to buy at 780, 40 points below the market price, so your contract is worth about $4,000: 40 times $100.”
You can sell put and call options on stock indexes and pocket the premiums. These trades are risky, though, because your losses are unlimited if the market moves against you. Ryan advises investors to start slowly when it comes to investing in options. Websites from the Chicago Board Options Exchange (www.cboe.com) and the Options Industry Council (www.888options.com) can help you weigh your options in this risky but potentially rewarding market.
WORDS TO THE WISE
STOCK INDEX OPTIONS
Publicly traded rights. Prices move in sync with the performance of a specified stock market index.
Options to buy at a certain price up to a certain date.
Options to sell at a certain price up to a certain date.
Price at which an option can be exercised.
TRIPLE WITCHING HOUR
Final trading hour of the third Friday of the month, when listed options expire.
An option that has current value. Either (1) a call where the exercise price is below the trading price or (2) a put where the exercise price is above the trading price.
An option with no current value.