Options Trading

Conversions

Like Reversals, conversions are often used by savvy traders in an attempt to capitalize on minor price discrepancies between Calls and Puts. Like other arbitrage strategies, a conversion involves buying something in one market and simultaneously selling it in another to capitalize on whatever small discrepancy exists between the two.

When options are relatively overpriced, a trader would buy stock on the open market and sell the equivalent position in the option market. Theoretically, this is a strategy with very little risk because the profit is locked in immediately. The idea here is to create a synthetic short position and offset it with a long position in the same underlying stock. The synthetic short position is created by selling a Call and buying a Put with the same strike price and expiration.

Combining the synthetic short position with a long stock position creates a conversion:

• Short call + long put + long stock 
• Profit potential: limited
• Loss potential: limited
• Break-even point: Call price - put price = stock price - strike price

Index Options

By definition, an index is a group of stocks traded or listed as one entity, such as the Dow Jones Industrial Average (DIA) or the S&P 500 (SPX). There are literally hundreds of different indexes traded throughout the world, with many tied to securities on the U.S. exchanges.

There are several advantages associated with trading the indexes themselves, as well as a number of different investment vehicles available with which to trade them. Some of these investment vehicles include: managed index funds - where your contributions are managed within a mutual fund that specifically targets the various funds themselves; or index tracking stocks (also known as exchange traded funds or ETFs), or the most exciting vehicle of all, index options.

Most index options are heavily traded and carry large premiums. This makes them ideal for selling time, as with a Covered-Call, or to show dramatic increases in the option value for a given movement in the underlying index by virtue of the leverage associated with options.

Unfortunately, not all indexes are optionable. For the purposes of our discussion, we'll only focus on optionable indexes.

Most Common Optionable Indices:

It's probably safe to assume you are somewhat familiar with most, if not all, of the indexes. However, let's quickly review the names and common ticker symbols for the optionable indexes we'll be discussing (notice that many of the indexes listed have more than one ticker symbol).

Complete definitions for these indexes can be found at the CBOE Web site at http://www.cboe.com.

You may be wondering why there are so many different ticker symbols for the various indexes listed. The reason is that each of the different ticker symbols represents a completely different security, tracking the same base set of stocks, but often following a completely different pricing structure.

Here's an example: the SPX tracks the performance of the top 500 companies in the Standard & Poor's index. The XSP also tracks the S&P 500, but at 1/10th of the value of the SPX.

Another possible variation between option types is their exercise style: American-style options vs. European style options. There are advantages and disadvantages to each discussed below.

American vs. European Style Options

Many European investors also trade on the U.S. exchanges, enjoying the protection of the U.S. regulated markets and the wide variety of financial instruments available. Many European traders are also attracted to the trading flexibility possible with American-style options.

The main difference between an American style option and a European style option is when they can be exercised. European-style options can only be exercised on the day they expire, which tends to reduce the risk to the option seller. With either American or European-style options, you have the ability to buy or sell the options at any time prior to expiration - it's the freedom to exercise the options that is the real difference.

Most options based upon an underlying stock are American-style options. American-style options can be bought and sold or exercised to take possession of the underlying stock at any time prior to expiration. Since most index options are tied to the value of a basket of stocks, there is no physical stock to possess – these options are cash-settled. Most cash-settled options are of the European variety.

If you imagine yourself as the seller of an index option, (think Covered Call) you can see how advantageous it could be to know with certainty that you won't awaken early one morning to find that your index option contracts have been exercised, leaving you on the hook for a hefty cash settlement. You only need to worry about settlement on the day of expiration and at no other time. This gives you the comfort of knowing that you're free to "buy-to-close" your contracts to cover an upside-down trade and limit your losses rather than being forced to turn over a large cash sum – as long as you do it before expiration day. This protection from potential down-side risk clearly works to the advantage of the option seller. Sellers of American-style options run the risk of being "called out" and having their options exercised at any time. For this reason, American-style options have a greater premium than European-style options for a given option position.

SPX:

One of the most actively traded indexes and some of the most actively traded options contracts come from the S&P 500. This benchmark index is generally traded by large institutional traders with plenty of cash at their disposal. The options contracts are expensive and volatile. It is not unusual to see the SPX index move anywhere from 2 to 30 points in a single day.

The SPX trades as a European-style option and can only be exercised on expiration day. The last day you can actually trade the SPX is the Thursday of the week the contracts expire. The options are cash settled at the price of the open on expiration Friday. SPX options are pricey, but each point in movement of the S&P 500 index is equal to a $100 movement in the SPX.

Other than the European-style exercise date for the SPX, the options are just like any regular option, officially expiring on the Saturday following the third Friday of the option's expiration month. Options in the SPX are traded through the Chicago Board Options Exchange (CBOE) and are traded in the Central time zone from 8:30 a.m. to 3:15 p.m., Monday through Friday.

XSP (aka Mini-SPX):

The XSP follows the same core basket of stocks as the SPX, but at only 1/10th of the cost. This brings the option much closer to the price range of individual investors, resulting in fairly significant daily trading volumes. For example, if the SPX were currently valued at $1500, the XSP would have a value of $150.

DIA:

Mention the U.S. stock market anywhere in the world and people will likely think of the Dow Jones Industrial Average (DIA). This index is one of the more popular with investors worldwide due to its versatility and diversity. The stock symbol DIA can be traded as an Exchange Traded Fund (ETF), just like an individual stock. The DIA, along with all other ETFs, is traded on the American Stock Exchange. Information regarding the DIA, as well as other ETFs, can be found on the American Stock Exchange Web site at http://www.amex.com.

One strong benefit of ETFs like the DIA is the diversity they offer. With one position, you have a portfolio diversified among 30 stocks. Plus, it can be shorted on a downtick.

You can play options on the index as well. Since the DIA acts like any other optionable stock, Covered Calls are an effective way to leverage your investments.

Options on the DIA are American-style, meaning they can be exercised any time prior to options expiration. Since the underlying stock can be bought and sold, DIA options result in physical settlement of the option trades. Thus, in the event you sell a Covered Call and you are called out, you need to sell the underlying stock to the option buyer to settle the transaction.

DIA options are also traded on the CBOE, which is open Monday through Friday from 8:30 a.m. to 3:15 p.m., Central Time. DIA options can be traded up to the closing bell on expiration Friday for their individual expiration month (though the true expiration date is the third Saturday of the month the options expire).

DJX:

Investors who prefer to trade indexes as a straight index and not as an ETF can trade the Dow Jones Industrial Average as an index option with the DJX. This option trades at roughly 1/100 of the Dow and follows the rules of a European-style option. Thus, the last day to trade the DJX is the Thursday before expiration, with the settlement price locked in at the open on expiration Friday. The DJX is traded on the CBOE, so trades are processed from 8:30 a.m. to 3:15 p.m., Central Time, Monday through Friday.

QQQQ:

Investors wanting to trade the NASDAQ 100 (NDX) can trade the index as a stock using the ticker symbol QQQQ. This index is often referred to as the Q's, or the triple Q. This ETF carries the same characteristics as a normal stock, yet provides you with a diversified portfolio of 100 of the NASDAQ's largest companies.

The QQQQ offers options with a physical settlement. So if you exercise options on the QQQQ, you can take physical possession of the stock by purchasing the shares at the option strike price. The QQQQ is traded on the CBOE.

The QQQQ tracks the average price of the top 100 companies of the NASDAQ. At the time of this printing, the QQQQ was averaging about $35 per share. This means that not only is the stock relatively affordable but the options aren't all that expensive either.

NDX:

If you're approved for Level 5 trading authority, you may want to consider the advantages of trading naked index options on the NDX, one of which is a much higher premium. Also, because there is no stock to own, options on the NDX are cash settled. Another characteristic of the NDX is that is a European-style option.

If you have Level 5 trading authority, the premium associated with NDX options can be quite attractive. If you were to look at the premium for the at-the-money Call for next expiration month on the QQQQ and the at-the-money Call for next month on the NDX, you would see that the difference in premium is significantly higher for the NDX.

RUT:

The Russell 2000 (RUT) is an index that continues to gain popularity. The RUT actually tracks the smallest 2,000 of the 3,000 largest stocks in the U.S. markets. It's a European-style option that is cash settled on expiration Friday. As with the previous examples, the RUT is traded on the CBOE, open for trading from 8:30 a.m. to 3:15 p.m., Monday through Friday, Central Time.

Caution: Only experienced investors who understand how to make volatility work for them should trade index options. Index options can be quite volatile and expensive, so if you're a novice to options investing, this shouldn't be the first strategy you try.

Practice before entering your first index option trade. There isn't anything wrong with paper-trading index options until you're more confident in how an index moves.

Advantages of Index Options:

You may ask yourself, "Why would I want to invest in index options?" There are some very distinct and profitable opportunities associated with index options. Here are a few:

Index options can be traded both on the long side and the short side for profits in either an up or a down market.

Since you are trading an index, you no longer need to scour the markets for a stock. This helps make more efficient use of your research time.

Each index is a combination of many different stocks, so fundamental analysis is not necessary. Also, index options are short-term plays, so you're only concerned with the stock's technical merit.

Because index options are generally traded by large institutional investors who move hundreds of contracts at a time, they are extremely liquid. Individual investors have the ability to move in and out of index options without attracting any attention.

An index represents a wide-ranging group of stocks, so your portfolio is immediately diversified.

Risks of Index Options:

Although index options have many benefits, they also carry some risks:

l Index options can be very expensive, which can lead to big losses. It only takes one or two of big losses to empty an options account.

l Index options are heavily traded and are subject to high volatility. Wide price swings in the SPX and XSP in particular are not unusual and can result in extraordinary price ranges throughout the day. Unless you're able to track options price quotes throughout the day, you may be in for a surprise at the end of the day when you discover an unexpectedly large loss in your trading account.

l The volatility of some exchanges can leave an index that started in a positive position at a large loss by the end of the day. The Dow has been known to swing from a gain to a 100-point loss in just a few trading hours.

l If you are a buyer of time (Calls), an option could fall in value even if the index is steadily moving higher. This is due to the fact that index options are extremely overvalued and that time value erodes quickly as the index nears expiration day.

How Does an Index Option Compare to a Stock?

Until you compare the two, the differences between stock options and index options can be difficult to visualize. But let's see how the two react to price movements. For this example, let's consider options on the OEX and Ford Motor Company.

With the OEX trading at $498, the closest Call option is the $500 Call with an option premium of $10. The $500 Put premium is trading at $12.

On the other hand, Ford is trading at $10.77. The $10 Call option is trading at $1, even though it has $0.77 of intrinsic value. The $10 Put for Ford is trading at $0.20.

The OEX options are more expensive because the value of the OEX is tied to the S&P 100 index (which is made up of 100 stocks). By contrast, options on Ford are tied to the value of a single stock. This is an important factor to consider. Although the OEX options look expensive, the premiums are large because traders think there is a chance to profit from the transaction.