Help

optionsguy > Blogs

optionsguy: Blogs

View All optionsguy's Blogs | View All Community Blogs

Index options explained: part 3

optionsguy posted on 04/08/07 at 08:00 PM

In my last post in this series on index options, I explained the difference between index-based options and those based on ETFs which are, in turn, modeled on various indices. Before that we dug into the basics of how index options work. Now, to the good stuff! How can you put index options to use in your trading and investing? I'll run through two main ones in this post and the next: hedging your broad-based portfolio, and speculating on an entire sector while minimizing your selection risk.

Hedge a broad-based portfolio with index options.

If you're bullish but nervous, buying puts in an index option can help hedge against losses on a broad-based portfolio. Here's how it works. Say your portfolio is composed of a lot of the same big-chip stocks in the S&P 500. To protect yourself against losses, you could buy put options on each of stock you own, or buy just a few puts on a single index, the S&P 500. To decide on the right number of index options, focus on the value of the portfolio you're looking to "insure". If the SPX trades currently at 1421, 1 put option in SPX represents $142,100 worth of portfolio or market value protected. Alternately, you could choose SPY, the options based on an exchange-traded fund related to the same index. Buying roughly 10 SPY's would cover the same amount of portfolio value as a single SPX option. Again, keep in mind that settlement styles, expiration, assignment and other terms might be different for these two securities. (I should also mention that, while index options can be used to hedge against losses as described, they're not actually insurance products.) Just like real insurance, you might save a little money by accepting a "deductible". In the options world, that means forgoing expensive at-the-money (ATM) options for cheaper out-of-the-money options -- 5% below the market is often a safe bet. That way, if the market slides, you'll lose only 5%, but if the market rallies or stays the same, you'll have paid considerably less for the options "protection" -- eating less into your overall gains. Last stop in this series is another use for index options, speculating on an entire sector. Tune in again soon!

Regards,

Brian (OG)

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.

Edited by optionsguy at 04/04/08 at 02:41 AM
Share This! Report

Posted by optionsguy on 04/08/07 at 08:00 PM

Tag It | 1 user tagged it: TradeKing, ETFs, index options, learning, education

Comments

User Avatar
User Avatar Brokerage Account

JonathanEvans

Member since: Feb 07
Trades Not Shared
Trade Notes 0
Blog Posts 1

JonathanEvans
Posted April 08, 2007 (08:00PM)
One thing that would really be a great improvement is adding extra columns in the holdings, gains/loss, and other screens that show the options in an account valued at the midpoint of the current bid ask spread. I am holding some thinly traded options and often the last market price is well outside of the current bid ask range.
Reply Report
Anonymous
Posted April 08, 2007 (08:00PM)
Hi Brian,
nice blog here. where in this blog to discuss more about Iron Condors & BWBs ?
looking forward to it.

cheers
Ivan
Reply Report
Anonymous
Posted April 09, 2007 (08:00PM)
Hello Ivan,

Thanks for the kind words; I hope you keep reading. I will eventually talk about Iron Condors and Broken Wing Butterflies, but I have not written about them yet.

Keep an eye on the TradeKing Learning Center, too, under the Education main menu. I plan to do some webinars on this topic for the CBOE webinar series, probably in a month or two.

Regards,

Brian (OG)
Reply Report
User Avatar
User Avatar TradeKing Staff Member

optionsguy

Member since: Dec 05
Trades Not Shared
Trade Notes 0
Blog Posts 126
Director of Education
Age: 30's
Charlotte, NC UNITED STATES
optionsguy
Posted April 10, 2007 (08:00PM)
Jonathan: We will usually value the options on the ask if you are short or on the bid if you are long. The issue is currently aftermarket sometimes; the quote service wipes out the posted bid ask and the only value we can get is the last trade. When only the last trade is being posted the system uses that.

We're working on a way to capture and database the bids and asks, but I am not sure how long that will take to accomplish. It's a harder task than it first seems.

Regards,

Brian (OG)
Reply Report
User Avatar
User Avatar TradeKing Staff Member

optionsguy

Member since: Dec 05
Trades Not Shared
Trade Notes 0
Blog Posts 126
Director of Education
Age: 30's
Charlotte, NC UNITED STATES
optionsguy
Posted April 10, 2007 (08:00PM)
Jonathan: We will usually value the options on the ask if you are short or on the bid if you are long. The issue is currently aftermarket; sometimes the quote service wipes out the posted bid ask and the only value we can get is the last trade. When only the last trade is being posted the system uses that.

We're working on a way to capture and database the bids and asks, but I am not sure how long that will take to accomplish. It's a harder task than it first seems.

Regards,

Brian (OG)
Reply Report
User Avatar
User Avatar TradeKing Staff Member

optionsguy

Member since: Dec 05
Trades Not Shared
Trade Notes 0
Blog Posts 126
Director of Education
Age: 30's
Charlotte, NC UNITED STATES
optionsguy
Posted April 10, 2007 (08:00PM)
Hello Ivan,

Thanks for the kind words; I hope you keep reading. I will eventually talk about Iron Condors and Broken Wing Butterflies, but I have not written about them yet.

Keep an eye on the TradeKing Learning Center, too, under the Education main menu. I plan to do some webinars on this topic for the CBOE webinar series, probably in a month or two.

Regards,

Brian (OG)
Reply Report
User Avatar
User Avatar Brokerage Account

JonathanEvans

Member since: Feb 07
Trades Not Shared
Trade Notes 0
Blog Posts 1

JonathanEvans
Posted April 11, 2007 (08:00PM)
Brian, Thanks for the clarification. I am glad to see that the valuation shown is therefore, aside from commissions, on a conservative valuation basis. It might still be interesting to see an extra column with valuation based on the midpoint of the bid ask.

I have had some problems with execution of midpoint orders on thinly traded options. However, my general experience is that most of the time midpoint limit orders work very well. In fact I am wondering if placing GTC limit orders at the bid for buying and at the ask for selling, and just waiting a day or so might not usually result in execution. Although normally you would be behind the big market makers in the queue of orders, I would assume that when the underlying moves the market makers are pretty quick to adjust their bid ask quotes. So I would think over the course of a day or two such orders might still have a high probability of getting executed.
Reply Report
User Avatar
User Avatar Brokerage Account

JonathanEvans

Member since: Feb 07
Trades Not Shared
Trade Notes 0
Blog Posts 1

JonathanEvans
Posted April 11, 2007 (08:00PM)
Sorry, I meant to say ''..., on a liquidation basis.'' in the previous post.

Another question I have is about tickers for various indexes and statistics.

I have recently gotten into a lot of charting and technical analysis. I really like the Thomson charting services in TradeKing. I also use a program called Amibroker with a utility called AmiQuote that downloads end of day quote histories from yahoo. I am interested in doing technical analysis not just on stocks and ETFs, but also on indexes, sectors, industries, and other time series, such as the advance decline/line. I know about the tickers for sector spdrs, such as XLI, etc. Do you know if there are free data sources or at least a good list of tickers for for things like individual commodity prices, individual industry indexes, advance/decline lines, etc. ? Preferrably the tickers would correspond to time series downloadable from yahoo or msn.
Reply Report
User Avatar
User Avatar TradeKing Staff Member

optionsguy

Member since: Dec 05
Trades Not Shared
Trade Notes 0
Blog Posts 126
Director of Education
Age: 30's
Charlotte, NC UNITED STATES
optionsguy
Posted April 22, 2007 (08:00PM)
Jonathan: In regards to displaying valuation based on midpoint, we would have to store that midpoint data in order to always have a value in the midpoint field. We are working on it, but it will be a while.

As for your other point: yes, it is possible to fill at the midpoint on a heavily traded option, but there is a time and place for every type of order. If the stock is moving quickly it's very hard to trade at the midpoint no matter how liquid because by the time your order gets to the floor the market could have moved.

Also, one thing that is not correct in your comment is that the market makers orders take precedence. Individual customer orders are always moved to the front of the line. Now if another individual gets to market first with the same limit they will be filled ahead of your order, but market makers can't trade ahead of your order.

Regards,

Brian (OG)
Reply Report
The above content is provided for educational and informational purposes only, does not constitute a recommendation to enter in any of the securities transactions or to engage in any of the investment strategies presented in such content, and does not represent the opinions of TradeKing or its employees. TradeKing provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment advice. You alone are responsible for evaluating the merits and risks associated with the use of our systems, services or products. All investments involve risk, losses may exceed the principal invested, and the past performance of a security, industry, sector, market, or financial product does not guarantee future results or returns. Your use of the TradeKing Community is conditioned to your acceptance of all TradeKing Disclosures and of the TradeKing Community Terms of Service. 2007 TradeKing.
The content and stock or option symbols on this page are for educational and informational purposes only and should not be considered a recommendation or solicitation to invest in a particular security or type of security. Your use of the TradeKing Community is conditioned to your acceptance of all TradeKing Disclosures and of the TradeKing Community Terms of Service. © 2009 TradeKing.
Testimonials may not be representative of the experience of other clients and are not indicative of future performance or success.
Quotes delayed at least 15 mins. Market Data provided by Interactive Data. Terms & Conditions. Powered and implemented by Interactive Data Managed Solutions.