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Option Master Chapter 9
Download the Option Master Manual - PDF 187k

 

Software for Pricing Options
by Kenneth R. Trester
and Robert P. Swanson


Chapter 9 - Playing the Index Options -- The Art of Pricing Index Options


The Hottest Game in Town

One of the hottest games in the investment markets today is not stock options, but index options. Index options give you that rare opportunity to bet on the price action of the whole stock market, rather than just one stock. Index options have several other advantages, such as cash settlement (where you don't get involved with delivery of stocks), and attractive tax treatment.

Finally, there is fantastic liquidity in some of the index options such as the S & P 100 Index options, where you can move in and out of positions with great ease, and you can usually use market orders without fear.

However, these advantages have drawn many option players into the index options game, and based on recent evidence, it has taken a big chunk of liquidity out of the stock options markets. In fact, the CBOE and other exchanges are now providing monthly expirations for some stock options to make them more attractive and draw some investors back into that game.

But with the many advantages to index options, there are some hidden disadvantages that you must be aware of. For many investors, index options -- such as the S & P 100 Index options -- can be a Shangri-la, but at times the odds are stacked against you with index options, and should probably be avoided.

Option Buyers Beware

The dramatic popularity of the broad based index options has drawn many small investors into this game, and most investors are buying these options. Due to the unique nature of the broad based index options, these options have a tendency to be overpriced, and hence, many investors playing this index options game are making bad bets.

If you have had any experience at all in the options market, you know that you cannot afford to buy overpriced options. Also, the tremendous popularity of these index options has drawn most of the best players into this market, and therefore, it is difficult at times to find bargain-priced options in the index options arena. So, if you are an index options buyer, at times it may be wiser to go hunting in the stock options markets rather than buying overpriced index options.

The Impact of Futures on Index Option Pricing

At times in the past, index calls and puts on the broad based indexes such as the S & P 100 Index (OEX) have had a tendency to be overpriced, and there are a variety of reasons why these options were overpriced. First, many investors have been drawn into the index options markets and are option buyers, driving up option prices. In addition, institutions use index puts for portfolio insurance, driving up their premiums.

Also, one of the major determinants of the pricing of these index options is the underlying index futures contracts. The broad based indexes on which options are traded usually have futures contracts that are also traded on these indexes. To be brief, futures contracts are agreements to take delivery of the index of stocks at some date in the future. Such delivery as would occur in other futures contracts -- such as gold futures -- does not occur with index futures, but rather a cash settlement occurs, as it does with index options.

As an index options investor, you should be concerned with the index futures contract because it is one determinant of whether index puts and calls are over- or underpriced. When the futures index price is higher than the actual index (for example, if the S & P 500 Index is priced at 465, but the S & P 500 December futures contract is priced at 467), under these circumstances, the S & P 500 call options are likely to be overpriced, and the futures contract usually is higher priced than the actual index for a variety of reasons.

First, when investors feel that the market is going to move up, this anticipation is registered in the futures contract which becomes higher priced than the index itself. But there is another fundamental reason and that is that the futures contract buyer, in a sense, puts up a small amount of money to buy a large amount of stock. Therefore, the premium in the index futures contract is a reflection of the present interest rates, or the cost of holding that amount of stock, less dividends paid by the stocks within the index. When interest rates are above dividend payments (which they usually are), the index should therefore have a premium over the actual index price.

Then why are index calls overpriced if the index futures contract is higher priced than the actual index? Well, professionals are not stupid -- when they see a difference between a futures contract price and the actual index price, they sell the futures contract at the higher price to take advantage of the fact that the index futures price must fall to the index price by the time the delivery date arrives.

But most professionals survive because they are hedgers. To offset the risk of selling a futures contract (which involves unlimited risk), they may buy index call options to hedge their position. When there is a lot of call buying, this of course forces the premiums up on call options, and therefore the calls become overpriced.

At times there has been a healthy difference between the futures contract price and the actual index price. As a result, S & P 500 Index calls have a tendency to be overpriced. When there is anticipation that the market will fall, there is a discount where the index futures contract would be priced less than the actual index price. Under these circumstances, the reverse would occur -- the puts would become higher priced.

What does all this mean to you as an index options investor? Well, by looking at the difference between the index futures contract price and the actual index, you can determine if index call or put options are likely to be overpriced and by what magnitude. In other words, when the index futures contract price for delivery in a nearby month is priced several points above the actual index price, the index call options are likely to be overpriced.

Active Traders Beware

Extremely active traders who use options strictly as a very short-term trading vehicle -- where they hold a position for only a few hours, and not more than a few days -- will enjoy the index options market because they do not lose much by buying overpriced options and holding them for a short period of time. But the longer you hold an overpriced option, the more the odds turn against you. If you plan to buy index options for more than a few days and you want to buy calls, we suggest some caution. Be careful not to pay too much for such options.

Spreading -- A Better Alternative

Rather than buying index option that are overpriced, one-on-one vertical index spreads may be a wiser choice. The proper spreads can reduce the cost of an index option by up to 50%, and you still have a bet on the price action of the whole market (although you do limit your profits). One-on-one vertical spreads have the same limited risk feature of buying options if you use spread orders to enter and exit, which is easy to do with OEX options.


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