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.
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.
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.
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:
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.
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
Open to the public:
Sequoya Branch of the Madison Public Library
4340 Tokay Blvd.
Madison, WI 53711
Contact: Jared Bessert, 608-298-9008, [email protected]
September 17th, 2014
6PM to 8:30 PM
Seminar starts about 7PM:
Midway Hotel Brookfield
1005 South Moorland Road
Brookfield, WI – 53005
Contact: Katherine McCombe, 262-523-8310, 800-965-4967, [email protected]
September 18, 2014
6PM to 8:30 PM
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.
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])