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:
- Purchase of index calls. If you believe that the index is likely to rise in the near future, buying calls is the most basic strategy.
- Purchase of index puts. The opposite applies when puts are involved. If you believe that the underlying index is likely to fall in the near future, the index put will become profitable. Because the put is based on falling prices of the underlying, in-the-money declines in the index will be matched by increases in the index put's value.
- Selling of index calls. If you think the index is going to fall in value, selling calls might be preferable to buying puts. However, if the index were to rise, the risk on this short strategy is, in theory, unlimited. The possibility of a broad-based index rising in double- or triple-digit ranges is probably unlikely in the short term, but it is impossible to quantify or limit the potential risk.
- Selling of index puts. Selling a put will be profitable as long as the index point value remains at or above the put strike. While the short call has a theoretical unlimited value, the short index put is actually limited. In the very worst-case scenario, an index could go to zero, but this is quite unlikely as components involving stocks will be cushioned by tangible book value of the companies. Futures-based or currency indices are equally unlikely to decline to the worst-case levels, so short put traders are probably able to quantify likely losses based on historical index movements, the breadth of components, and current market conditions and sentiment.
- Index spreading. Another way to make use of options with indices as the underlying is through spreading between two different indices. Because indices with similar underlying components (i.e., based on stock values) tend to track each other fairly consistently, the risk in spreading between indices is limited. However, if the spread involves indices with dissimilar components (i.e., stocks in one and commodities in another), the risk elements will be much greater, especially on the side of the spread that is shorted. (This risk can be mitigated, however, by using long calls and puts, rather than a long and short side in the spread.)
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.