How to Trade Index Options
Index options are option contracts that trade against the price changes of a specific index instead of against specific stocks. Options are contracts to buy or sell the underlying security at a specific price for a set period of time.
If exercised, index options settle in cash rather than the delivery or receipt of shares of stock. Trading index options allows the trader to profit from price trends of the overall market or a specific sector without being surprised by news from a specific stock.
Index options can be traded on broad market indexes or indexes that track mathematical concepts such as the Chicago Board Options Exchange (CBOE) volatility index.
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Instructions
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Pick the index on which you want to trade options. Review the price chart to determine the current price trend, up or down.
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Enter the symbol for the index in your online broker account quote screen. Select "option chain" to see the options available for the index.
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Narrow the option chain by selecting "near-the-money" and the next month's or the following month's expiration date. If you believe the index will rise, select "call options." Select "put options" if you are predicting an index decline. The result will be a small focused group of options from which to trade.
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Select the option you want to trade and click on the trade button. The in-the-money strike price nearest the current index value provides a good balance of profit potential for a small change in the index value and low price per contract.
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Enter the number of contracts you wish to trade and set a limit price about halfway between the bid and ask prices. Remember the cost of an option contract is 100 times the price. Place the order.
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Monitor the status of the order. If it is not filled within the first five minutes, review the index value, bid and ask prices. Make adjustments to your limit price if necessary.
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When the order is filled, set a stop loss order to close the position if the index moves in the wrong direction.
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Monitor the index and option values, taking a profit when the projected index value is reached.
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Tips & Warnings
The Options Industry Council and CBOE websites have extensive education programs to learn advanced option trading strategies. If the index options are well in the money at expiration, they can be allowed to automatically exercise and settle for cash. Buying call or put options is a good strategy if you believe the index will make a strong move in an up or down direction.
Option contracts that are out-of-the-money at expiration will expire worthless, resulting in a 100 percent loss of the purchase price. Option trading requires extensive knowledge and discipline. Do not trade options without understanding all of the possible outcomes.
