Event Trading: Index Options

By: Peter McKenna

The following is an excerpt from Peter McKenna's The Event-Trading Phenomenon

Imagine that you are an event trader, and that day after day sellers have dominated the trading action, driving the market to greatly oversold levels.  Recent economic indicators have been negative, which means the economy is crawling along.

Now imagine that before the bell, Microsoft announces spectacular earnings and say its future earnings appear strong as well.  The market is oversold and there are no prevailing conflicts or uncertainties.  The market will very likely go up, perhaps way up.

It’s time for you to act, to jump into an index call option.  The first step is to decide which call to buy.  If all goes well, all the indexes will go up and you will earn a profit no matter which index you choose.  In my opinion, however, some indexes are better than others for event traders.  I rank them as follows, beginning with the best:

S&P 500 Index (SPX)
S&P 100 Index (OEX)
Dow Jones Industrial Index (DJX)
NASDAQ 100 Trust (QQQ)
NASDAQ 100 (NDX)

The reasons for these rankings are based on safety concerns rather than potential profits.  Options based on the Nasdaq 100, ranked last on my list, are powerful.  They can make you a lot of money in a short amount of time.  But when the market turns against you, these contracts are wicked, and the losses can be staggering.  Here’s why.

The price you pay to buy an index option is called a premium.  Premiums are determined by a computer-driven formula that measures, among other variables, the historic volatility of all stocks in an index and the time left until expiration.  This formula is called Delta.

The Nasdaq 100 index is comprised of 100 highly volatile stocks traded mainly by speculators and day traders.  It can register large gains and losses in a short amount of time.  This means the calls and puts based on this index can also register large gains and losses in a short amount of time.  If you are holding a Nasdaq 100 call when the index goes way up, you can make a considerable amount of money.  Conversely, if you are holding a put when the index goes way down, you can also make a considerable amount of money.

Because they offer this potential for making large gains, Nasdaq 100 options are dangerously expensive.  At the time of this writing, the Nasdaq 100 Index was trading at 1025.  The August 1025 call, an at-the-money contract, was trading at $74.80, or $7,480 per contract.

Paying more than $7,000 for a single contract is fine if the market indeed goes up.  At-the-money contracts are priced on what’s called a 50% delta.  This means for every one point rise in the Nasdaq 100 Index, the price of the contract will go up $0.50.  If you buy the contract for $74.80 when the index is at 1011, and it goes up just one point to 1012, your contract will be worth $75.30, or $7,530.

Of course, a one point increase is nothing on a good day.  Suppose the index goes up 45 points.  The value of your contract will go up by $22.50, to $97.30, or $9,730.  You have just made $2,200 on one contract (minus commissions).  Five contracts will give you $11,000 and ten contracts will give you $22,000.

But, you will not like what happens to your money if the market goes against you.  Let’s say the market is soaring when suddenly another corporate scandal is announced, or there is another terrorist attack.  When this news hits the market, introducing an element of uncertainty, the index can lose 45 points in a heartbeat, well before you can get to your computer and close out the position.

Contract pricing is based on the same delta on the downside.  You will lose $0.50 for each drop of one point in the index.  If you failed to use a stop loss order and the contract falls 45 points before you can act, your loss will be $2,200 on one contract, $11,000 on five contracts and $22,000 on ten contracts.  A stop loss order limits the amount of your loss if the market turns against you.  It is an order to sell if the price drops below the purchase price by a predetermined amount.

If you are disciplined enough to always use a stop loss, and if you can afford to take the relatively hefty loss you will incur even if you use a stop loss, by all means consider these contracts.

As stated, an at-the-money contract has a 50% delta.  This means the price of a contract, either a call or a put, will go up $0.50 for every 1 point rise in the S&P 500 Index.  But this ratio applies only to at-the-money contracts.  As you go further out of the money, you will make progressively less than $0.50 for every one point rise in the underlying index.  Contracts that are way out of the money can rise to a delta of about 95%.  At this level, a one point rise in the index will cause a $0.95 increase in the value of the contract.

Remember, the at-the-money level is the pricing pivot point for the 50% delta.  Also remember that the delta declines as expiration nears.  A week before expiration, the delta will be cut almost in half on all index options.

A Sliding Scale

The 50% delta applies to at-the-money Nasdaq 100 and S&P 500 contracts.  These calls or puts will go up or down $0.50 for every one point gain or loss in the underlying index.  The S&P 100 Index and the Dow Jones Industrial Index are based on slightly less than 50% delta.  These at-the-money calls and puts will go up and down about $0.48 for every one point gain or loss in the underlying index.  Lastly, the at-the-money contracts based on the Nasdaq 100 tracking stock, the QQQ, is based on a much lower delta.  They move at a rate of about $0.30 for every one point rise. 

With so many contracts available, and with their prices changing every second, it is difficult for investors to determine the exact Delta for an in-the-money or out-of-the money contract at any given moment.  The Chicago Board Options Exchange (CBOE) has a free options calculator available on their website that makes the job easy.

Let’s return to the hypothetical scenario from above.  Remember, Microsoft’s strong earnings announcement is likely to drive the market upward.  You want to participate in this opportunity to make money.  Which contract should you buy, and how many should you buy when the market opens?

The best way to address these questions is to compare the prices of in-the-money, at-the-money and out-of-the-money call contracts on all the available indexes.  Your strategy will evolve from this information.