Buying Index Calls

[Igor 10]

Traders who buy index calls are betting that the market price of the underlying asset will go up. The strategy involves buying a call that's associated with a stock market index. The index will play the same role as the underlying asset does in normal options trading. Investors settle their exercised options in cash, so there are no assignment of assets. When traders buy index calls, they enter the market at lower costs, which limits their risk. The most a trader can lose is the amount that he or she pays in premiums. At the same time, there is no limit to how much profit an investor can make, since the potential growth of any stock index is infinite.

 

How to Buy Index Calls

A trader buys an index call in the same way that he or she would buy a regular call option, except that the underlying asset is not just one stock but rather a collection of many.

Example: GOOG, is valued at $400

 

 

The following At-The-Money (ATM) call index option is available.

GOOG Jan 400($4.50)

- One Option contract

- Strike Price $400, expiring on 1/15

- Premium Cost of $4.50

 

Trader buys one index call option and pays $450 [$100 x $4.50 (premium cost)].

 

Result: The trader is in the options market for $450, and he or she can exercise the GOOG option if it's In-The-Money (ITM) when it expires.

 

Advantage and Disadvantage of Buying Index Calls:

 

Pluses: The upside to this type of strategy is that there are no limits to the amount of profit an investor can make. If the stock index's value takes off, the investment will grow, and the trader will exercise and settle for cash when the option expires. Another advantage is that the cost of entering the market is very low. As a result, the lower buying cost limits a trader's overall risk and exposure.

 

Minuses: The downside in buying index calls is the investor loses money when the value of the stock index falls. Although, the most an investor can lose is only the amount that he or she paid in premiums to buy the option.

 

Examples of Buying an Index Call Using the (ATM) Order Above:

 

GOOG increases to $420 (ITM).

Result: The value of the option expires at $420 and is ITM. The investor will exercise the index call, receiving $2000 from the writer.

[$420 (market value) - $400 (strike price) = 20 x $100]

The trader's profit will total $1550, after subtracting the $450 in premiums paid.

 

GOOG stays at to $400 (ATM).

Result: The value of the option expires at $400, and even though it is breaks even-ATM, it's still worthless. The investor will receive no profit from the investment, and their total loss is $450, what was paid to enter the market.

 

GOOG declines to $380 (OTM).

Result: The value of the option expires worthless at $380 and is Out-of-The-Money (OTM). The investor will receive no profit from the investment, and their total loss is $450, what was paid to enter the market.

 

Choosing the Correct Strike Price

In looking at the example above, the trader bought the index call with a strike price ATM for $400. Investors can also buy index calls OTM, which are less expensive but carry more risk. Alternatively, a trader who purchases a call index with a strike price ITM will pay more, but they will also have a greater chance that the option will expire ITM.

 

Examples of Buying an Index Call with Strike Price (OTM):

 

GOOG is trading at $400.

GOOG Jan 500($1.50)

- One Option contract

- Strike Price $500, expiring on 1/15

- Premium Cost of $1.50

Trader buys one index call option and pays $150 [$100 x $1.50 (premium cost)].

Result: The trader is in the options market for $150, but GOOG must increase to more than $501 (25%) for the above option to expire ITM.

 

Examples of Buying an Index Call with Strike Price (ITM):

GOOG is trading at $400.

GOOG Jan 300($7)

- One Option contract

- Strike Price $300, expiring on 1/15

- Premium Cost of $7

 

Trader buys one index call option and pays $700 [$100 x $7 (premium cost)].

Result: The trader is in the options market for $700. GOOG can decrease to $371 (-23%) and the option above will still expire ITM. Any price above $371 will lead to substantial profits.