Index Options Introduction

Published: 17th February 2011

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INDEX OPTIONS INTRODUCTION

Options’ very existence is due to traders who wanted to minimize their risk, i.e. people who wanted to be long or short a specific asset, but only at a specific price, and who wanted not to be financially responsible if the market moved the opposite direction. Therefore, using options in trading can be a particularly useful tool for securities traders who are concentrated in a specific sector of the market or are trying to beat a specific index.
For instance, let’s say you have picked a portfolio of large cap U.S. companies. You feel good about your picks; there is no specific stock which worries you more than any other, but you know there is inherent risk that economic news could shatter other traders’ bullishness and the entire market may move lower altogether. How can you protect against this risk? Well, you could think about selling off your positions whenever the market gets jittery, and then buying them back when you feel good again, and then selling and buying and selling and buying the same securities over and over as the mood strikes you. But think of the transaction costs!

You have a better alternative - using stock index options. These options are fully fungible and exchange traded, so they are the simplest way to go short conditionally and hedge your portfolio. In this instance, you would buy a put on the Dow Jones Industrial Average, and once you’ve paid that put’s premium, you would have no further risk of loss in that option position, and your risk of loss in your portfolio would be minimized by the gains you’d make on the index put in the event of a drawdown. Index options are financially settled; you wouldn’t be assigned an actual basket of DJIA stocks if you exercised your put.
Of course, you could use any stock index with exchange-traded options, and therefore match any portfolio for hedging purposes. But another powerful way to use options in trading is to not just see these index options as a hedging tool, but as a great opportunity for total market exposure … with leverage. Here is a way to go short (or long) on an entire slice of the market, and doing it this way makes it even so much easier to buy one put (or call) of 30 diversified stocks, in the case of the DJIA, than even shorting (or buying) one individual company.

All the risk management benefits of puts and calls are still in place for stock index options (you only have to exercise the position if it is profitable to do so), as do all the trading opportunities for option sellers. With an opinion on market direction, you can use options in trading to gain easy exposure to an entire index.

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