Writers of covered calls and cash-secured puts use stocks or exchange-traded funds as the underlying securities. It is the value of these securities that give value to our option premiums. For example, we will buy back an option when share price moves down causing the corresponding option to decline in value as well. We may also buy back an option when share price rises exponentially causing the strike sold to move deeper in-the-money and the time value of that option now nearing zero. The relationship between share value and option premium is critical to our covered call writing and put-selling results. In this article, I will discuss another underlying security, the stock index and the options associated with them, index options and I will compare them to options associated with similar exchange-traded funds or ETFs.
Definitions
Stock Index
A stock index is a statistic that reflects the composite value of a basket of stocks. Stocks listed within an index bear similar characteristics such as trading in the same stock exchange, belonging in the same industry or having comparable market capitalizations.
Exchange-Trade-Fund (ETF)
An ETF is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value (per-share dollar amount of the fund is calculated by dividing the total value of all the securities in its portfolio, less any liabilities, by the number of fund shares outstanding) over the course of the trading day. Most ETFs track an index, such as a stock index or bond index.
Charting SPY (ETF) and $SPX (Index Fund)
SPY and $SPX charts of the S&P 500
The two charts look exactly the same with the ETF price trading @ $200 and the Index fund price trading @ $2000. To get a better understanding of the differences between an ETF option and an index option, I created this comparison chart:
Comparing ETF and Index Options
Exercise of index options
If $SPX was priced @ $2000 and the $2000 call was priced @ $10, the breakeven would be $2010 and any price above $2010 would result in an account credit and any price below $2010 would cause an account debit. This is known as cash-settlement. The maximum loss is the amount paid for the call option. The maximum gain is theoretically unlimited. European style index options can only exercised on the day of expiration while ETF American style option can be exercised at any time from the purchase or sale of the option through expiration Friday.
Summary
The main differences between equity (ETF) and index options occur primarily in the underlying instrument and the method of settlement. Many of our members have been using ETF options as a core income-generator in our covered call writing and put-selling portfolios. Index options can be used by buying and selling calls and puts depending on market outlook.
Next 2 live seminars:
September 17, 2014
1- Madison Wisconsin Subgroup of AAII
Open to the public:
Madison
Meeting location:
Sequoya Branch of the Madison Public Library
4340 Tokay Blvd.
Madison, WI 53711
(608) 266-6385
Contact: Jared Bessert, 608-298-9008, [email protected]
September 17th, 2014
6PM to 8:30 PM
2- Milwaukee Wisconsin Chapter of the American Association of Individual Investors
Seminar starts about 7PM:
Milwaukee/Brookfield
Meeting location:
Midway Hotel Brookfield
1005 South Moorland Road
Brookfield, WI – 53005
(262) 786-9540
bestwesternplus.hotelsavings.com/
Contact: Katherine McCombe, 262-523-8310, 800-965-4967, [email protected]
September 18, 2014
6PM to 8:30 PM
Market tone
There were very few economic reports this past week but the few that came out continued to show economic growth:
- According to the Commerce department, retail sales in August rose by 0.6%, in line with analyst expectations. August sales were 5% higher than a year ago, the largest in 1 -year
- According to the Federal Reserve, consumer credit (spending) increased by $26.0 billion in July to $3.24 trillion resulting in an annualized growth rate of 10%, the largest in 3 years. This was the first time since the recession of 2008 that revolving balances have accelerated for 5 straight months, reflecting growing consumer confidence
- According to the Commerce Department, business inventories increased by 0.4% in July
For the week, the S&P 500 declined by 1.1%, for a year-to-date return of 9%, including dividends.
Summary
IBD: Confirmed uptrend
GMI: 4/6- Buy signal since 8-15-14
BCI: Moderately bullish favoring out-of-the-money strikes 2-to-1
My best to all,
Alan ([email protected])
Alan,
I know there must be an obvious answer to this but curious why you publish weekly stock reports but recommend monthly options. I’m enjoying my membership and really excited about learning all about options.
Thank you!
Chris
Chris,
The report we use the most is the one immediately after expiration Friday. However, there are times we will close one of our positions with one of the exit strategies detailed in my books/DVDs. In those situations we want our members to select a replacement security using the most up-to-date information and so we screen our stocks weekly.
Alan
Two additional (and major) differences between ETFs and the underlying indexes are:
The ETFs have more volume, and so the bid-ask spreads are narrower; the indexes can be harder to trade (especially if you want to exit the position early).
Index options cannot be exercised early. This eliminates a major and potentially unpleasant surprise. If you do spreads or condors, having one of the short strikes exercised early could be quite negative financially. With calls, the consequence are not so severe.
I believe that index options can be traded on the Saturday after Friday expiration. If so, taking action on the Friday, assuming the option had expired, could be premature.
Premium Members,
The Weekly Report for 09-12-14 has been uploaded to the Premium Member website and is available for download.
Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the BCI YouTube Channel link is:
http://www.youtube.com/user/BlueCollarInvestor
Best,
Barry and The BCI Team
Hi Alan,
What if I buy a stock (e.g.) BX & 32,37 and sell ITM @ 32 and OTM @ 33 in the same time.
Isn’t it a kind of diversification ?
Thanks for your opinion.
Petr
Petr,
It sure is. Strike price diversification is a sound approach to cc writing when selling multiple contracts on the same underlying. If your overall market assessment is bullish and chart technicals are positive, we are more likely to favor OTM strikes and vice-versa. Personal risk tolerance also plays a role. At the end of my weekly blog articles I share my current strike price diversification based on my overall market assessment and my personal risk-tolerance.
Good point.
Alan
Premium members:
This week’s 8-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site. The report also lists Top-performing ETFs with Weekly options as well as the implied volatility of all eligible candidates.
For your convenience, here is the link to login to the premium site:
https://www.thebluecollarinvestor.com/member/login.php
NOT A PREMIUM MEMBER? Check out this link:
https://www.thebluecollarinvestor.com/membership.shtml
I am currently in Milwaukee, Wisconsin and hope to see local BCI members at my seminars in Madison and Brookfield on Wednesday and Thursday, the 17th and 18th of this month.
Alan