How to Trade Stock Options Against Indexes
Stock options are among the most flexible and risky investments in the financial industry. These contracts can be bought and sold just like stock, but carry significantly greater risks. Stock options are always tied to an underlying entity. Often, the underlying is a stock, but options can be traded with entire stock market indexes as the underlying. When options are traded against an index, their profit is based on the overall success of that index. A "call" option can be purchased to profit from an increase in the value of a stock index. A "put" option can be purchased to profit from a decline in the index. During bear markets, put options are popular instruments with which to benefit from a weakening economy.
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Instructions
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Open a brokerage account that offers the trading of stock options. Many mainstream brokerage houses offer this service, however some brokerages are specifically tailored to options traders. These brokers often provide lower commission rates for trading option contracts. Their trading platforms may have tools for analyzing the complex stock option pricing mechanism to better inform their clients.
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Apply for the option trading level that provides the buying of "puts" and "calls." Some brokerage houses require that clients gain access to option-trading privileges only after a separate application process is completed. There are many types of option trading, and the outright purchase of option contracts is often the second or third tier of access that a firm provides. Clients must indicate that they understand the risks and are aware of the techniques of trading options before some firms grant them this ability.
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Identify the entity that tracks the stock market index against which you wish to trade options. The main stock indexes, such as the Dow Jones Industrial Average, the S&P 500 and the Nasdaq all provide stock options. However the exchange traded funds (ETFs) that track these indexes also offer stock options, and the market for ETF options is much larger. The advantage of trading an ETF option is improved liquidity. Some options markets are so thin that even if you contain a profitable contract, you are unable to realize the profit in real dollars because there is no one to purchase it from you. Many index ETFs are available for your consideration.
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Predict a price movement in the stock index. Stock options, unlike stocks, require that you are correct not only in your prediction of a price change but also in the timing of this change. You cannot hold a stock option indefinitely as they all have expiration dates. If the index has not made a strong move during the life of the stock option contract, your investment could result in a 100 percent loss as the contract expires as worthless. Decide on a realistic price target to take place during a set period of time, usually one month to three years.
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Scan all the stock option contracts available in your trading platform. Each platform is structured differently, however all show the same information. First choose the index or ETF that interests you, then select the desired expiration month. Those options that expire soonest are said to be "front-month" options. Because they have little time before they expire, their values are often extraordinarily volatile as minute changes in the index can result in significant changes in the stock option. It is usually recommended that novice stock option traders refrain from engaging in the risks of front-month options.
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Choose a "call" option if you expect the index to rise. Pick a "put" option if you predict the index will fall. These two option types are usually separated on either side of the platform's option window.
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Select a "strike price" for the option contract. If the strike price is reached exactly by the expiration date of the option, a value of zero for the stock option results. However, option traders rarely hold onto an option position until expiration; thus it could still be profitable earlier in its life. But this strike price helps to put the risk into perspective. For this reason, it is often wise to choose a strike price lower than your expected target if buying a call, or higher than your expected target if buying a put. This ensures that the option will remain profitable for most of its life cycle should your prediction be correct. These will become "in-the-money" options because they usually hold at least some value.
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Purchase as many contracts as you wish. Options are priced at one-hundredth of their actual purchase value. Thus a single contract of an option priced at 65 cents would cost $65. Ten 65-cent contracts would cost $650. Most brokers charge a commission for each contract purchased.
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Monitor your position carefully. Option positions usually require substantially more maintenance than stocks due to their volatility. As soon as the option enters profitability, and if you have multiple contracts in the portfolio, it is wise to sell a portion of the position to lock in some gains. This will offset losses in the event the contracts' value reverses, as is very possible.
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Tips & Warnings
Due to the extraordinary volatility of stock options, it is wise to trade them only with capital that you can stand losing in its entirety. It is common for options trades to result in a 100 percent loss. Frequent option traders offset these losses, however, with gains that can sometimes reach 1,000 percent or more. The risks remain high at every stage in the process.
References
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