1. TRADING INDEX OPTIONS Tactics and Strategies
Presented by: The CBOE’s Options Institute

2. Disclaimer
In order to simplify the computations, commissions have not been included in the examples used in these materials. Commission costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any transactions.
Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities.
Options involve risks and are not suitable for everyone. Prior to buying or selling an option, an investor must receive a copy of Characteristics and Risks of Standardized Options. Copies may be obtained from your broker or from The Chicago Board Options Exchange, 400 S. LaSalle, Chicago, IL Investors considering options should consult their tax advisor as to how taxes may affect the outcome of contemplated options transactions.

3. Presentation Outline Motivation for Trading Index Options
Brief Review of Basics
Price Behavior of Index Options
Covered Writing “The Market”
Protecting a Portfolio
Volatility and Advanced Strategies

4. Motivation for Trading Index Options?
An individual stock has: Company Risk
Sector Risk
Market Risk
How can these risk factors be reduced?

5. Motivation for Trading Index Options?
Index options allow investors to enter “the market” rather than individual stocks.
View on the Market
View on an individual Sector
Protect your portfolio
Increase Income to the Portfolio

6. Features of Index Options
Index Options vs ETFs
Cash Settlement vs. Delivery
$100 Multiplier vs. 100 Shares
4. Exercise Style (American vs European)
5. Settlement Method (PM vs. AM)
6. Expiration Dates
7. Broad-Based vs. Narrow-Based
8. Calculation of Index Value

7. Index Options vs. ETFs 1 Index Options – cash settled options.
OEX (S&P 100® Index)
SPX (S&P 500® Index)
NDX (Nasdaq-100® Index Options)
DJX (Dow Jones Industrial Average)

8. Index Options vs. ETFs 2
Exchange Traded Funds (ETFs) - index-based investment products that allow investors to buy or sell shares of entire portfolios of stock in a single security.
OEF (iSharesSM S&P 100® Index Fund )
SPY (SPDRs® - Standard & Poor's® Depositary Receipts)
QQQ (Nasdaq-100 ® Index Tracking Stock)
DIAMONDS® (DIA)

9. Cash Settlement vs Delivery
ETF options settle with shares (like stock options).
Index options settle with cash.
Example: 560 Call with at exp.
Index Value
Less Strike Price
Net
x Multiplier x $100
Cash from Seller to Buyer $876.00

10. $100 Multiplier
The underlying value for each index option contract is $100 X the index value.
560
Underlying Value = 560 x $100 = $56,000
OEX
Price of Option = 11 x $100 = $1,100

11. Exercise Style
American-Style Exercise – an option that may be exercised at any time prior to the option’s expiration date.
European-Style Exercise – an option that may only be exercised at a specific time. Generally, this is the last day prior to the option’s expiration date.

12. PM Settlement
The closing price of each stock determines the settlement value of the index.
The last day of trading is typically a Friday.
- S&P 100® Index Options (OEX®)
- all listed stock options
- all listed ETF options

13. AM Settlement
The opening price of each stock determines the settlement value of the index.
The last day of trading is typically a Thursday.
Dow Jones Industrial Average (DJX)
S&P 500® Index Options (SPX)
Nasdaq-100® Index Options (NDX)
Russell 2000® Index Options (RUT)

14. APRIL, MAY, JUNE, SEPTEMBER
Expiration Dates
At least front two months plus at least two expirations from the March, June, September, December Expiration Cycle
Quiz: If today is March 28, options with which four expirations will be trading?*
APRIL, MAY, JUNE, SEPTEMBER
* Some index options have four near-term expirations available for trading.

15. Many Index Options Available!
Broad-Based Indexes – follow a wide range of stocks across many industries.
Narrow-Based Indexes – follow a specific sector or group of stocks within one industry.

16. Broad-Based Index Options
EYR - CBOE Asia 25 Index Options
EOR - CBOE Euro 25 Index Options DJX - Dow Jones Industrial Average OEX® - S&P 100® Index Options - American OEX® - S&P 100® Index LEAPS - American XEO® - European-style S&P 100® Index Options XEO® - European-style S&P 100® LEAPS SPX - S&P 500® Index Options SPX - (Reduced-value) LEAPS SPL - S&P Long-Dated Options SML - S&P® SmallCap 600 Index Options NDX - Nasdaq-100® Index Options MNXSM - CBOE Mini-NDX Index Options MML - CBOE Mini-NDX Long-Dated Options GTC - GSTI™ Composite Index Options NYA - NYSE Composite Index® Options RUT - Russell 2000® Index Options NFT - Morgan Stanley Multinational Company Index
OEX - S&P 100 Index - American-style Exercise
XEO - S&P 100 Index - European-style Exercise

17. Narrow-Based Index Options
Dow Jones Sector Index Options DTX - Dow Jones Transportation Average DUX - Dow Jones Utility Average DJR - Dow Jones Equity REIT Index MUT - Dow 10 Index
ECM - Dow Jones Internet Commerce Index
CBOE Sector Index Options
GOX - CBOE Gold Index Options
INX - CBOE Internet Index Options CBOE Internet Index (Reduced-Value) LEAPS OIX - CBOE Oil Index Options TXX - CBOE Technology Index

18. More Narrow-Based Index Options
Goldman Sachs Technology Index Options
GHA - GSTI™ Hardware Index Options GIN - GSTI™ Internet Index Options GIP - GSTI™ Multimedia Networking Index Options GSM - GSTI™ Semiconductor Index Options GSO - GSTI™ Software Index Options GSV - GSTI™ Services Index Options GTC - GSTI™ Composite Index Options
Morgan Stanley Index Options International Index Options
MVR - Morgan Stanley Retail Index Options EYR - CBOE Asia 25 Index Options MVB - Morgan Stanley Biotech Index Options EOR - CBOE Euro 25 Index Options MGO - Morgan Stanley Oil Services Options MEX - CBOE Mexico Index Options NFT - Morgan Stanley Multinational Company Index EFA – Morgan Stanley EAFE IShares

19. Price Behavior of Index Options

20. Buying Index Options 1a Today is September 20.
The OEX is currently 500.
The December OEX 500 Call is currently 20.
Your forecast:
The market will rise 10% by December expiration
Question:
If your forecast is correct and you buy 1 OEX 500 Call, how much will you make?

21. Buying Index Options 1b OEX on 9/20 500  550 (+ 10% in Dec)
OEX 500 Call  (+150%)
Profit calculation
Sale Price of Option = 50 x $100 = $5,000
Cost of Option = 20 x $100 = $2,000
Net Profit = 30 x $100 = $3,000
Maximum risk = $2,000 = cost of option

22. Buying Index Options 2a Today is September 20.
The OEX is currently 500.
The December OEX 500 Call is currently 20.
Your forecast:
The market will rise 10 index points in 1 week.
Question:
If your forecast is correct and you buy 1 OEX 500 Call, how much will you make?

23. There are two important concepts you must know.
Buying Index Options 2b
OEX on 9/  (in one week,
on 9/27)
OEX 500 Call  ??
What is your forecast for the price of the OEX December 500 Call?
There are two important concepts you must know.

24. Concept #1 - Delta Most options don’t move as much as the underlying.
A measure of the rate of change in an option’s price for a one unit change in the price of the underlying assuming all other factors are unchanged.
Note: Different options have different deltas
example: in-the-money calls tend to have higher deltas (approach 1.00 or 100%)
example: out-of-the-money calls tend to have lower deltas (approach 0)

25. Concept #2 - Time Decay
Option
Value
Time to Expiration
-0- Days
Option prices generally do not decrease at the same rate that time passes to expiration.

26. Time Decay (continued)
Index Level 500
Days to Exp 90
Px of 500 Call
500 60
500 30 ?
16.30 ?
11.50

27. Index Options 2b CONCLUDED
OEX on 9/  (in one week, on 9/27)
OEX 500 Call 
Delta: at-the-money options have a delta of approximately 50% (underlying up/down by 1 point and option price up/down by ½ point)
Time Decay: Very little initially. This example involved only 7 days (out of 90 days to exp.)

28. Deltas Change!
Index:
500 Call:
Delta:
(180 days to expiration)
Call: +5.60
Delta: +0.06
Call: +6.10
Delta: +0.05
Call: +6.60
Delta: +0.04

29. Planning a Long-Term Investment

30. Planning for the Long Term
You plan to invest $10,000 per year over the next 3 years in a DJIA Index fund.
You want approximately $30,000 of market exposure today.
You can use DIA LEAPS® options to target this objective.

31. Planning Ahead
The DJIA ETF (DIA) is currently trading at $92 per share
The DIA January 2005 LEAPS 92 Call is trading at $8.
Step 1?
Step 2?
Step 3?

32. Planning Step 1 Step 1 - Today - Deposit $10,000 in your account
Buy 3 DIA January strike LEAPS® Calls at $8 each (Total Cost $2,400 + comm.)
Account balance = $7,600

33. Planning Step 2 Step 2 – Next 2 Years
(any month) – Deposit$10,000
(account balance = $17,600)
(January) – Deposit $10,000
(account balance = $27,600)

34. Planning Step 3 – Market Up
Step 3 – DIA above $92 in January 2005
-If still bullish: exercise calls and purchase 300 DIA at $92
-Total cost 300 x $92 = $27,600 + comm. ($27,600 cash in account)
-You can sell the calls if you wish. Taxes?

35. Planning Step 3 – Market Down
Step 3 – DIA below $92 in Jan 2005
Calls expire for a total loss of cost of calls.
There is still $27,600 (+ int.) in account.
Buy more than 300 DIA or invest elsewhere?

36. Covered Writing on The Market

37. Covered Writing - A Definition
The Covered Call Strategy consists of selling calls on a share-for-share basis against stock that is owned.
(Simultaneously buying stock and selling calls is known as a “buy-write.”)

38. Covered Writing on “The Market”
Buy an ETF and sell calls
- Dow Jones Industrial Average
Buy DIA and sell DIA calls
- S&P 100 Stock Index
Buy OEF and sell OEF calls
- NASDAQ 100 Stock Index
Buy QQQ and sell QQQ calls

39. Why Sell Covered Calls? Forecast: neutral to moderately
bullish on the stock
Goals: increase returns in
stable markets and
reduce stock price risk

40. What You Should Know The seller of a covered call:
has the obligation to sell stock at the strike price (at any time, if assigned).
until the expiration date.
In exchange for accepting the obligation, the call seller receives a premium.

41. Covered Writing Example
Buy 100 shares of $51.00
and
Sell 1 OEF Nov 53 $0.90
(It is 80 days prior to October expiration, and the OEF will pay one dividend of $0.14 before expiration.)

42. Profit and Loss Table Buy OEF @ $51.00, Sell 53 Call @ 0.90 55 53 51
Stock at Long OEF Short 53 Call Total
Expiration P/L at Exp. P/L at Exp Profit/Loss 55 53 51 50 45 ?
+4.00
+2.00
-0-
-1.00
- 6.00 ?
(1.10)
+0.90
+2.90
+0.90
-0.10
- 5.10

43. Profit/Loss Diagram Buy OEF @ $51.00 & Sell 53 Call @ 0.90 53 
Long $51.00 50 -5 45 55 +5
Covered Call

44. Calculating the Static Return
The static return assumes that the price of the underlying is unchanged at expiration and the call expires worthless.
Note: Return calculations assume that the same per-period profit can be earned repeatedly throughout the year, and this may not be possible.

45. Static Return Worksheet
Call Price less Commission _____
Plus Dividends + _____
= Income = _____
Divided by Stock Px plus Comm  _____
= % Income = _____
Times 365/____ (Days to Exp) x _____
= Annualized Static Return = _____
0.90
0.14
1.04
51.00
2.0% 80
4.5
9.0%
B.C.
Commissions not included

46. Calculating the If-Called Return
The if-called return assumes that the underlying price rises above the strike price and that the call is assigned at expiration. This means that the underlying is sold at the strike price.
Note: Return calculations assume that the same per-period profit can be earned repeatedly throughout the year, and this may not be possible.

47. If-Called Return Worksheet
Call Px – Comm + Div = = _____
Strike Px – Stock Px = – = _____
= Income + Gain = _____
Divided by Stock Px plus Comm  _____
= % Income = _____
Times 365/____ (Days to Exp) x _____
= Annualized If-Called Return = _____
1.04
2.00
3.04
51.00
5.9% 80
4.5
26%
B.C.
Commissions not included

48. After the Break Protecting a Portfolio Trading Spreads
Advanced Strategies

49. INTERMISSION

50. Protecting a Portfolio
Protective Put defined:
Purchasing a put in conjunction with a long stock position or an owned portfolio. 37

51. Protective Put Example
Own a $200,000 Portfolio that matches the S&P 500 Index.
The Index is currently at 1,000.
Action:
Buy 2 6-month SPX 975 Puts 37

52. Protective Put Case Study
Your portfolio is worth $200,000.
You cannot afford to let the value fall below $180,000.
You want to protect yourself and stay in the market at the same time. 37

53. Protective Put Case Study
1,000
Own a $200,000 portfolio. The S&P 500 is ______
Buy ________________________ @ ______
x Index Multiplier ______ Total Cost of Puts (x 2) ______
2 6-mo SPX 975 Puts
40.00
$100
$8,000
Cost  4.0% of portfolio for 6 months 38

54. Profit/Loss Diagram S&P 500 Portfolio @ 1000 & 975 Put @ 40.00
Protective Put
Unhedged Portfolio
+50
Protected Portfolio
925
950
975
1000
1025
1050
-50

55. Protective Put Case Study
Minimum value at option expiration?
Maximum value at Jan ’05?
Below index level of 975, rise in put
value offsets fall in portfolio value.
Minimum value = $187,000 (-6.5%)
Index level x $100 x 2 less cost of puts.

56. “Low-Cost” Protection
You are bearish on the market short-term.
You think that index puts are “too expensive.”
How can you bring in cash to pay for (or reduce the cost of) the index puts?
Sell covered calls on some of the individual stocks in your portfolio. Use the cash to pay for the index puts.

57. Protective Puts - Pros & Cons
Protection below a known index level
Unlimited upside
Cons:
Protection has a cost
Limited time period 20

58. Advanced Strategies 1
Vertical Spreads

59. Vertical Spreads Defined
The purchase of one option and simultaneous sale of another option with the same underlying, the same expiration date, but with a different strike price.
Vertical spreads are usually established in a margin account.

60. Bull Call Spread - Example
(30-day Target: 500  +3%)
Buy (1) RUT 30-day 480 Call @
Sell (1) RUT 30-day 500 Call @
Net Debit
This spread is purchased for a net payment of $960 plus commissions.

61. Bull Call Spread - P&L Table
Index 480 Call 500 Call Spd Spd Spd
At Exp Value Value Value Cost P/(L)
510
500
490
480
30.00
20.00
10.00 ? ?
10.00 ?
20.00
10.00 ?
9.60
10.40
0.40
( 9.60)
Buy (1) RUT 480 Call @ RUT @ 485
Sell (1) RUT 500 Call @
Net Debit

62. P / L Diagram At Expiration15 12 9 6
Profit 3
& -3
480
485
490
495
500
505
Loss -6 -9
-12
-15
Below 480
All Options Expire
Cash Value
Above 500
Max Profit

63. Trading Vertical Call Spreads A Shorter Term Perspective
Do I Have to Hold Until Expiration?
No. Spreads can be closed at any time, during trading hours, just like individual options.

64. How will a bull call spread change in price prior to expiration?
Price Behavior
How will a bull call spread change in price prior to expiration?

65. Strategic Considerations
Delta Analysis
Delta
Long 1 30-day 480 Call
Short 1 30-day 500 Call
Net Delta

66. Vertical Spreads - Summary
Lower susceptibility to time decay than at-the-money options.
Understanding the mechanics is important.
Extra commissions are likely.
The strategy of choice when the forecast is for a gradual price rise in the underlying stock.

67. Advanced Strategies 2
Credit Spreads

68. Collecting Option Premium
The Credit Spread
The sale of one option (close to the money) and the simultaneous purchase of a different option (out of the money) with the same underlying and the same expiration.
The short option is considered covered by the purchased option, and the margin requirement is the difference between strike prices, less the credit received.

69. Credit Spread Example 16.50 483.50 Example: on 8/22 with TXX at 465.00
You believe the index will not rise above 480.
Sell 1 Sep 480 TXX Call @
Buy 1 Sep 500 TXX Call @
Net Premium Received:
Maximum Risk:
Break-even point at exp.
16.50
483.50

70. Credit Spread Example +3.50 (16.50) Sell 1 Sep 480 TXX Call @ 5.50
Buy 1 Sep 500 TXX 2.00
Net Premium Received: 3.50
+3.50
480
500
465 Current
Index Level
(16.50)

71. Advanced Concepts 1
Volatility

72. Forecasting Index Price Index Price Strike Price Strike Price
Days to Exp. Days to Exp.
Int Rates & Div Int. Rates & Div
Implied Volatility Implied Volatility
= Mkt Px of Option = Mkt Px of Option
WHICH COMPONENTS CHANGE? 

73. VOLATILITY IS A MEASURE OF RISK
Mathematical definition
Intuitive understanding

74. Types of Volatility
Historical actual volatility during a specified time period
Future
actual volatility from present to option expiration
Implied
volatility that justifies an option’s current
market price
Forecasted
estimate of future volatility used in computer
models to calculate theoretical values

75. Implied Volatility
The volatility percentage used in an option pricing formula that returns the market price of an option as the theoretical value.

76. 17.75% ?? Implied Volatility Index Level 469 470 Call
Strike Price Market Price
Days to Exp
Int. Rates %
Dividends %
Volatility
17.75% ??

77. “High Volatility” – What To Do
Vertical spreads have reduced exposure to decreases in implied volatility.
SPX Index Change
Implied Volatility 30% 20% -10%
975 Call
1000 Call
Spread

78. Volatility Skew “Volatility skew” defined:
A market condition in which options on the same underlying trade at different levels of implied volatility.
It is normal for a volatility skew to exist among index options.

79. Volatility Skew 7/19/99 SPX - 1407.65 VIX - 19.47 Imp. Vol. Imp. Vol.
AUG 1250 Put 26.2% AUG 1400 Call 17.3%
AUG 1275 Put % AUG 1425 Call 16.3%
AUG 1300 Put % AUG 1450 Call 15.3%
AUG 1325 Put % AUG 1475 Call 14.7%
AUG 1350 Put % AUG 1500 Call 14.0%
AUG 1375 Put % AUG 1525 Call 13.9%
AUG 1400 Put % AUG 1550 Call 13.8%
Source: CBOE (32 days to Aug expiration)

80. Volatility Skew SPX 993.36 8/28/03 VIX 20.42%
Implied Vol Implied Vol.
SEP Call 16.1% SEP Put %
SEP Call 15.8% SEP Put %
SEP Call 15.6% SEP Put %
SEP 1005 Call 15.5% SEP Put %
SEP 1015 Call 15.0% SEP Put %
SEP 1025 Call 14.6% SEP Put %
SEP 1040 Call 14.5% SEP Put %
Source: CBOE (22 days until September expiration)

81. VIX – CBOE’s Market Volatility Index
CBOE introduced VIX in 1993, and it has since become the most widely followed benchmark for stock market volatility.
VIX measures market expectations of near term volatility conveyed by stock index option prices.
Since volatility often signifies financial turmoil, VIX is called the “investor fear gauge”.

82. VIX – Volatility Index
OEX versus VIX

83. OEX versus VIX Jan ’03 – Aug ‘03
VIX – Volatility Index
OEX versus VIX Jan ’03 – Aug ‘03

84. VIX is Changing!
“New VIX” (VIX) effective 9/22/03, there will be a new VIX calculation based on the implied volatility of S&P 500 Index options (SPX).
“Old VIX” (VXO) is based on the implied volatility of S&P 100 Index options (OEX). VXO will continue to be calculated and available from most quote vendors.

85. How Much the Market Moves
Advanced Concepts 2
How Much the Market Moves

86. For Those Who Sell Naked Options
Many people sell uncovered calls and puts.
It is a misconception that “90% of options expire worthless.” Only about 33% of options expire worthless. The rest are closed or exercised.
The following statistics are presented for informational purposes. There is no guaranty that market movements in the future will mimic those of the past.

87. Estimating Probabilities 1
If I sell index options, how far out-of-the-money does a strike price have to be for me to “feel safe”?
Can I sell an options 5% away?
10% away? 20% away?

88. Estimating Probabilities 2
From the current month’s close to the next month’s high (low), how much did the OEX rise (fall) in the last 10 years?
On average?
Two-thirds of the time?
Average rise: 2.4%
Average fall: 4.8%
Rise: 5.5%
Fall: 5.3%

89. Estimating Probabilities 3
From the current month’s close to the next month’s high (low), what is the largest percentage rise (fall) in the last 10 years?
Largest percentage rise:
Largest percentage fall:
23.5%
21.2%

90. Estimating Probabilities 4
From the current month’s close to the next month’s high (low), how often was the rise (fall) greater than…
> 5%:
> 10%:
Rise > 5%: 24% of all months
Fall > 5%: 50% of all months
Rise > 10%: 9% of all months
Fall > 10%: 15% of all months

91. What Do Probabilities Tell Us?
The market moves more on a short-term basis than many people realize.
Blindly following “trading systems” is very risky. Judgment is essential at every step.
Manage capital so as to stay in business.
Close trades and take profits and losses.

92. Advanced Strategies 3
Time Spreads

93. 1x1 Time Spread Example: Call Time Spread (SPX @ 900)
Buying one option and selling another option of the same type, with the same underlying and same strike price, but with a different expiration date.
Example: Call Time Spread 900)
Buy 1 56-day 925 SPX
Sell 1 28-day 925 SPX
Net Cost of Spread:

94. Time Spread - Estimating P/L
SPX Index  / 900
Days to Exp 28/56  18/46 / 18/46
Short 925 Call  / 10.30
Long 925 Call  / 21.90
Time Spread  / 11.60
+13%
Index unchanged in 10 days
+ 32%
Index at 925 in 10 days

95. Time Spread – Volatility Down
SPX Index  / 900
Days to Exp 28/56  18/46 / 18/46
Volatility 20%  15% / 15%
Short 925 Call  /
Long 925 Call  / 15.80
Time Spd  /
-12%
Index unchanged in 10 days
- 0 -
Index at 925 in 10 days

96. Time Spread - Conclusions
Neutral market strategy
Near zero delta
Profitable for “small” rise or fall in the underlying (with implied volatility unchanged)
Time decay is major benefit
High exposure to changes in implied volatility
Time spreads are a “low-volatility” strategy

97. Advanced Strategies 4
Diagonal Spreads

98. 1x1 Diagonal Spread Example: Call Diagonal Spd – SPX @ 900
Buying one option and selling another option of the same type, with the same underlying, but with a different strike price and a different expiration date.
Example: Call Diagonal Spd – 900
Buy 1 56-day SPX
Sell 1 28-day SPX
Net Cost of Spread:

99. Diagonal Spread - Estimating P/L
SPX Index  / 900
Days to Exp 28/56  18/46 / 18/46
Short 925 Call  / 10.30
Long 900 Call  / 26.20
Diagonal Spd  / 15.90
+13%
Index unchanged in 10 days
+ 50%
Index at 925 in 10 days

100. Diagonal Spread – Volatility Down
SPX Index  / 900
Days to Exp 28/56  18/46 / 18/46
Volatility 20%  15% / 15%
Short 925 Call  /
Long 900 Call  / 19.80
Diagonal Spd  / 13.00
- 8%
Index unchanged in 10 days
+ 33%
Index at 925 in 10 days

101. Diagonal Spread - Conclusions
Directional strategy
Benefits from time decay if implied volatility is unchanged
Decrease in implied volatility has negative impact

102. The Decision-Making Process
Trade in units of capital.
(not in numbers of contracts)
Know implied volatility levels.
Make a 3-part forecast.
Underlying price, time period, impl. vol.
Analyze more than one alternative.
Trading options requires planning.

103. Thank You for Attending
Contact us at:
The Options Institute
1-877-THE-CBOE then press 4,3
Questions:
Courses:
CBOE
CHICAGO BOARD OPTIONS EXCHANGE