Index Option Strategies

Many of the strategies you can apply with stock-based options also work for index options. However, because settlement occurs in cash and not in stock, some stock-based exercise strategies will either not apply or will have different outcomes.

Following are many of the possible strategies you might consider with index options:

In picking an appropriate strategy, individual risk tolerance has to be a primary factor. For example, those who cannot tolerate a great deal of risk should limit their exposure to long call and put positions. The use of short index options is appropriate for those willing to assume greater risks and, unlike stock-based options, short positions cannot be covered by owning the underlying directly.

To "cover" a short position in an index option, there are some ways to approximate the protective features of a covered option. For example, you may own a long call that expires at the same date or later than an equivalent short call. As long as the long call's strike is identical or higher than the earlier-expiring short call position, it is completely covered. If the long position's strike is lower, it partially covers the short call, thus limiting the risk.

The same effect can be achieved with puts. A long put with a later or identical expiration or a later expiration than a short put covers the short position. If the long strike is identical or lower than the short strike, the short position is covered. When the long put's strike is higher, the risk in the short position is limited to the difference between the two strikes.

A form of option covering is also accomplished when you hold long positions in the index itself, and then write calls against the same index. Each well-known market component has an equivalent index in which shares can be purchased; and many additional indices track quite well. For example, the Value Line Index contains many of the same stocks as the S&P 500. So owning one index while writing short calls on the other index may accomplish a version of "cover" for the short position. However, you should be quite familiar with these indices and their options before embarking on an advanced spread aimed at creating a covered call situation.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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