Selling Index Calls

[Igor 10]

Traders who sell index calls are betting that the market prices of the index's underlying assets will fall. The strategy involves writing a call that's linked to a stock market index. The underlying index plays the same role as an asset does in options trading. Investors settle all index options in cash and there are no assignments of assets. When traders sell index calls, they predict that the index option will expire out-of the money. The profit potential and risk involved when using this strategy varies. Traders selling index calls limited their profits to the amount that they receive in premiums when selling a call. On the contrary, the loss-risk potential is unlimited, since any stock index can rise to as much as demand permits.

 

Moneyness Review for Calls

 

Out-of-The Money (OTM) = Strike price (more than) Market Price

In-The-Money (ITM) = Strike price (less than) Market Price

At-The-Money (ATM) Strike price (equals) Market Price

 

Understanding Index Options and Regular Options

 

Selling an index option functions the same way as in selling a regular option. The difference is that the underlying assets associated with index options are many compared to just the one underlying asset that's associated with a regular stock option.

Example: The NASDAQ is worth $4000 and its index option, NASX (Index Option), is valued at $400 (1/100 of the NASDAQ).

 

How to Sell Index Calls (ATM)

 

 

The NASDAQ is worth $4000 (market price) in June.

1) Trader sells an index call option: NASXDec400 ($4.50)

- One NASDAQ index option with a contract multiplier of $100

- Strike Price $400, at-the-money (ATM), expiring in 180 days

- Premium Cost of $4.50

2) Trader receives $450 for the sale (100 x $4.50 (premium cost)).

Total credit to enter the market: $450

 

Result one: NASX rises to $420 (ITM) in December.

a) The call option sold expires ITM. The buyer exercises his or her right to buy 100 shares at $40.

b) The difference between the option's strike price and the NASX is $20 (NASX: $420 - strike price:$400). There is no assignment of assets, so the trader uses the contract multiplier (CM) to figure the cash settlement.

c) The trader pays the buyer $2000 [100 (CM) x $20 (difference in prices)]. Adding the $450 credit received when entering the market reduces the trader's total loss to $1550.

 

Result two: NASX falls to $380 (OTM) in December.

a) The buyer lets the option expire and does not exercise the right to buy.

b) The buyer loses the premiums paid to the trader to enter the market. In this example, the trader keeps the $450 credit, which is the maximum profit for this type of trade.

 

Advantages and Disadvantages of Selling Index Calls:

 

Pluses: The upside to selling index calls is that the trader can enter the market without paying cash. He or she receives a credit, keeping the premium when the index option expires worthless and using the credit to offset losses in a bull market.

 

Minuses: The downside in selling index calls is that it limits a trader's profits to only the amount received when entering the market. If the market value of the underlying index bottoms out, the trader could not capitalize on the short sale. Also, the potential loss-risk in a selling call index is infinite, since any index could theoretically rise as much as its supply permits.

[TechnoloTRADE 10]

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