|
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.
Go to Chapter 10 | Return to Table of Contents
|
