Lately I've been getting some interesting questions about index options from investors I'm meeting at TradeKing educational events.  It's a pretty fascinating topic, since index options are not only increasingly popular, but there are quite a few small-but-critical nuances to understand about incorporating them into your strategy.

So I'll be digging into index options over the next few weeks, beginning with the key question: what are index options, and what exactly can you do with them?

Index options: the basics

Ever heard of the SPX (the S&P 500 Index) or the DJX (Dow Jones Industrial Average Index)?  Some of the most heavily traded options going, options based on these indices can provide a liquid, convenient way to hedge a broad-based portfolio, or speculate on a given sector - without having to cherry-pick the top stock in that sector.

What's an index option, exactly? It's an option based on a given index, a basket of stocks representing either a broad or narrow band of the overall stock market. Like equity options, index options' prices rise or fall based on several factors, including the value of the index (the underlying), strike price, volatility, time to expiration, interest rates and dividends paid by the various stocks in the index.

Unlike most equity options, which can be exercised at any point before expiration, most index options can't be exercised until expiration. Does that mean, if you buy an index call and the market goes up, that you can't make a profit until expiration? Luckily, the answer is no: just like stock-based options, there'll always be a market, and you'll be able to sell to close the position at any point.

Index options also differ from equity-based options, in that the last day to trade them usually is the Thursday before the third Friday of the month. On that Friday settlement value is determined, and this value is compared to the strike price of the option to see how much, if any, cash will change hands between the seller and the buyer. Note that word "cash" - indexes are cash settled. If you exercise an S&P 500 index option, there's no need to buy all 500 stock in the index.

Now for the disclaimer: all of these are very general characteristics of indexes. In practice, there are lots of small exceptions to these general rules. To find out more about the index option you'd like to trade, visit CBOE.com for the full story. In my next post, I'll explain the difference between index options and their similar-seeming cousins, options based on ETFs, which model themselves after a given index. Check back here soon!

Regards,

Brian (OG)

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

Hi Brian,

I love TradeKing.

One thing that is really challenging to me is placing option orders so as to not get eaten alive by the bid/ask spreads on small and mid cap stock options that are close to the money. I am not looking to profit from the bid/ask (aka scalping) or implied volatility trading, but just to ride the momentum of the underlying for a few weeks. So the bid/ask is a real killer.

Sometimes limit orders at the midpoint of the bid/aks go through pretty quick. Maybe I just need to place my midpoint limits and wait an hour or so ?? Do you have any advice or referral to a book, etc. where I could learn to improve my skills at placing orders to get good execution ?

Hello Jonathan,

I agree, when trading small caps it is very annoying to deal with the large Bid/Ask spreads. Sorry, but there is no book that I am aware of that will tell you how to enter the order to get a fill close to a midpoint. My experience has been much the same as yours: some will fill right away and others seem to never get filled. I usually enter them at the mid and if they don't fill quickly I then adjust the limit - an hour is a long time to wait. It really depends on how badly you want as to how much of a spread you are willing to pay.

I know this is not much help, but the good news is, it seems you have already figured most of the order entry process out on your own. I'm sure you'll observe more along the way, too.

Regards,

Brian (OG)

Hello Jonathan,

I agree, when trading small caps it is very annoying to deal with the large Bid/Ask spreads. Sorry, but there is no book that I am aware of that will tell you how to enter the order to get a fill close to a midpoint. My experience has been much the same as yours: some will fill right away and others seem to never get filled. I usually enter them at the mid and if they don't fill quickly I then adjust the limit - an hour is a long time to wait. It really depends on how badly you want it as to how much of a spread you are willing to pay.

I know this is not much help, but the good news is, it seems you have already figured most of the order entry process out on your own. I'm sure you'll observe more along the way, too.


Regards,

Brian (OG)

Hi Brian,
I really enjoy some of the information you give.
I am new into Option Trading. I do have some options going on right now.My question is this, is there away to make money on your call option after you buy one and it starts to drop on you so you can make up the differents in money that you have lost.I read somewhere about buying insurance like the same way you would buy insurance on your house.But, it never explain what they were talking about.I'm thinking that they met to also buy a put.If so would you buy the put at the same strike.Plus wouldn't that make your investment more expensive.Could you please give me some advise on this.
THANK YOU JIM