Index option trading is a subject that even those familiar with stock market jargon often know little about. But it is a way of trading options that is virtually risk free, where all you are risking is the premium you pay for the option, which is normally a small fraction of the potential profit you stand to make.
If this sounds a little technical, let me explain it in plain English.
The original method of making money on the stock market was to buy a company’s shares in order to sell them later at a profit.
Then options came along. Instead of actually purchasing stock, or shares, you could simply purchase the option to purchase. You didn’t become a shareholder so you couldn’t attend and vote at company meetings, and weren’t entitled to dividends, but as your main concern was to simply profit from an increase in the company’s value, and as you were probably doing the same thing with many companies, you probably weren’t concerned about this.
For example, if you consider the stock of XYZ Inc, current price $10.00, is going to increase in the near future, then you could buy an option to purchase, say, 1,000 shares at $10.00 each in, say, 3 months’ time. The premium, or cost, of the option might be 10 cents a share, total $100 (1,000 x $0.10).
Cheaper than buying 1,000 shares at $10 (total cost $10,000), eh?
In addition, your risk is less, because your maximum loss, if the price does not rise, is your premium of $100. If you bought the shares your theoretical risk would be $10,000, though admittedly only if the company was to go bankrupt and the shares become worthless. In spite of this, options are an excellent alternative to shares, and you can have an interest in many more shares for your money, which brings us to the next point.
If, as you anticipated, the share price does indeed rise, then you can make a massive profit. In our example, if the share price rose just modestly to $12 from $10 within the three months, by no means an unlikely event in the life of a company, then you would be able to sell your option for $2,000, i.e. you’d in effect buy the shares for $10 each, total $10,000, and sell them for $12 each, total $12,000. The profit is therefore $2,000, less the original $100 premium, giving a net profit of $1,900.
If it’s as easy as that, then why would anyone sell an option to you? For the same reason that people sell shares – because they might be of the view that the shares will probably go down in value.
So far, so good. But where does index option trading come into it? The trouble with the example I’ve just given is that individual stocks can be volatile and it can be very difficult to predict future price movements unless you are very familiar with what’s going on in that company. But you can easily do this with an index of a number of companies in a particular category.
For example, you may be keeping close track of what is going on in the utilities sector. Find a suitable index of the companies in that sector, track it, and when you consider a move upwards in price is due then purchase the index option. Or sell it if you think the price is about to go down. This has the advantage that any individual share volatility will be ironed out and you will be thereby protected.
Of all the stock trading tools you may find, this must be one of the best. If you keep yourself well-informed in a few sectors as I’ve explained, something that’s not too difficult to do, then you should be successful far more often than not, and given the risk/reward ratio explained above you should be able to make regular profits with minimal risk.