Options trading has caught the fancy of many investors in recent times.
This is not surprising.
The beauty of options is embedded in its very name.
You have the option but not the obligation to buy the underlying stock or asset.
Now unlike other investment, this limits the liability of an option's buyer to the limit of the premium that he/she had paid in buying the options contract.
Stock Indexes like S&P 500 give a broad measure of the health of the US economy.
If the S&P 500 Index is going up, it is considered that the US economy is doing good and if it is going in a downtrend, the US economy is considered to have entered into a recession.
In 1978, the Chicago Board Options Exchange (CBOE) began options trading on the popular stock indexes such as S&P 500 Index.
Now the CBOE options trades in multiples of $100 per index point unlike the S&P futures contracts that trade for $250 per index point.
An index options gives you the right to buy the stock index at the set point within a stipulated time.
Let's make it clear with an example.
Suppose you have bullish opinion of the market.
The S&P 500 Index is at 1200 points at the moment.
You buy a call index options contract at 1250 point for a period of three months for 30 points or $3,000.
This is the options premium that you pay for buying the right but not the obligation to profit from the market movements.
Now if the S&P Index moves above 1250 points, you will make $100 for each point the index rises above 1250 in the next three months.
Suppose the index reaches 1300 points, you make $5,000.
Your profit is $2,000=$5,000-$3,000.
Let's suppose, the S&P Index does not rise but instead declines to 1150 points.
In this case you just lose your $3,000 options premium that you had paid.
So you can yourself see that the index options contract gives you unlimited upside potential but limits your downside risk.
Buying call options is considered to be a bullish strategy.
Similarly you can buy a put index options contract if you have a bearish sentiment about the market.
In this case you will profit when the market declines.
So in our above example, suppose you had bought a put index options instead of a call index option with the same price, premium and expiry date, if the market went down to 1100 points, you would have made ($100)(100)=$10,000.
Not bad huh! Your profit is $10,000-$3,000=$7,000.
In case, the market had gone up to 1300 points, you would have lost only your $3,000 premium.
So with an index option, you are in a way able to buy the whole market such as represented by these stock indexes instead of owning a few stocks!
This is not surprising.
The beauty of options is embedded in its very name.
You have the option but not the obligation to buy the underlying stock or asset.
Now unlike other investment, this limits the liability of an option's buyer to the limit of the premium that he/she had paid in buying the options contract.
Stock Indexes like S&P 500 give a broad measure of the health of the US economy.
If the S&P 500 Index is going up, it is considered that the US economy is doing good and if it is going in a downtrend, the US economy is considered to have entered into a recession.
In 1978, the Chicago Board Options Exchange (CBOE) began options trading on the popular stock indexes such as S&P 500 Index.
Now the CBOE options trades in multiples of $100 per index point unlike the S&P futures contracts that trade for $250 per index point.
An index options gives you the right to buy the stock index at the set point within a stipulated time.
Let's make it clear with an example.
Suppose you have bullish opinion of the market.
The S&P 500 Index is at 1200 points at the moment.
You buy a call index options contract at 1250 point for a period of three months for 30 points or $3,000.
This is the options premium that you pay for buying the right but not the obligation to profit from the market movements.
Now if the S&P Index moves above 1250 points, you will make $100 for each point the index rises above 1250 in the next three months.
Suppose the index reaches 1300 points, you make $5,000.
Your profit is $2,000=$5,000-$3,000.
Let's suppose, the S&P Index does not rise but instead declines to 1150 points.
In this case you just lose your $3,000 options premium that you had paid.
So you can yourself see that the index options contract gives you unlimited upside potential but limits your downside risk.
Buying call options is considered to be a bullish strategy.
Similarly you can buy a put index options contract if you have a bearish sentiment about the market.
In this case you will profit when the market declines.
So in our above example, suppose you had bought a put index options instead of a call index option with the same price, premium and expiry date, if the market went down to 1100 points, you would have made ($100)(100)=$10,000.
Not bad huh! Your profit is $10,000-$3,000=$7,000.
In case, the market had gone up to 1300 points, you would have lost only your $3,000 premium.
So with an index option, you are in a way able to buy the whole market such as represented by these stock indexes instead of owning a few stocks!