Getting Started: Using Equity Index Options
by: Tom Boggs
Trading options on equity index futures is one of the easiest and most efficient ways to participate in the market.
For investors trying to determine which way the market will go or the amount of volatility expected, trading options on equity index futures is one of the easiest and most efficient ways to participate in the market.Use Them for Spreading
Options on equity index futures are an ideal investment product for spreading, which is trading one strike or month against another, either as a directional investment in the stock index or as a hedge against a portfolio containing the index or parts of the index. For this article’s examples, I use options on the CME E-mini® S&P 500® Index futures, which are only traded electronically on CME Globex®. Spreads of options on equity index futures are an efficient tool for acting on your view of market volatility. However, the beauty of all this is that you do not need a directional bias to trade options on CME E-mini S&P 500 index futures. But I will get to that in a bit. First, let’s look at how to trade market volatility. Volatility is a critical component in all option pricing models and leads to option premiums that reflect embedded implied volatility assumptions.
Straddles
Let’s take a look at two trades using options on the CME E-mini S&P 500 index futures spreads that can be used easily to trade volatility. These particular spreads are called straddles and strangles. A straddle is the simultaneous purchase (or sale) of an equal number of puts and calls with the same strike price and expiration dates. A strangle is the purchase (or sale) of a different strike put and a call in which the options have the same expiration.
We can focus on a long straddle strategy first. Straddle traders generally use at-the-money options, with strike prices at or very near the underlying index. So when the long straddle strategy is executed, the buyer pays a premium equal to the call price plus the put price. A straddle buyer generally believes that volatility will increase with the index moving dramatically up or down.
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CME E-Mini S&P 500 Futures
Options on the CME E-mini® S&P 500® Index futures are options on the CME E-mini futures, which trade at a $50 multiplier. The value of the CME E-mini index futures contract, when trading at 1,500 for example, is $75,000, or the index level multiplied by $50. Options on the CME E-mini S&P 500 Index futures also trade with a $50 multiplier. To calculate the dollar value of the option premiums in the included examples, you need to multiply the quoted premiums by $50. Thus, an E-mini options premium quoted at 10 equals $500.
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In Action
As an example, let’s look at the CME E-mini S&P 500 at-the-money 1545 September option straddle. These options settle into September quarterly CME E-mini S&P 500 index futures contract on expiration date, which is Sept. 21. On July 6, the September E-mini index futures contract was trading at 1,542.5 and volatility was approximately 15.5. If the straddle buyer purchased the September 1,545 call at 37 index points and the 1,545 put at 40 points, then the straddle was purchased at 77 index points (37 + 40 = 77).
The breakeven point on the upside for the straddle buyer at expiration is determined by adding the premiums to the strike price: 1,545 strike + 77 premiums = 1,622 breakeven on the upside. That means that above the level of 1,622, the spread becomes profitable as the call value exceeds the straddle purchase price.
Breakeven on the downside for the straddle buyer at expiration is determined by subtracting the premiums from the strike price: 1,545 strike - 77 premiums = 1,468. Below 1,468, the spread becomes profitable as the put value exceeds the straddle purchase price. These breakeven levels are determined purely on the basis of intrinsic value at expiration. See Figure 1.
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Straddle buyers are investing in significant index moves in either direction, up or down, and will, therefore, lose money if the index remains stagnant due to time decay. Losses, however, are predetermined and limited to the premium paid for the spread. If volatility were to increase substantially during the contract period, the options values would theoretically increase accordingly. This is why some traders use straddles to gain exposure to changes in volatility. If you think volatility is going up, you might consider buying straddles.
Conversely, straddle sellers generally believe that the index level will remain between these breakeven points or that volatility will fall during the contract term. See Figure 2. In the example, the straddle sellers remain profitable within the breakeven points as long as volatility does not increase substantially. The seller also may benefit from the normal time decay of the options. With less time remaining, the option values drop accordingly.
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Strangles
A strangle spread is similar to a straddle and is executed within the same contract month but uses different strike prices. This spread generally involves out-of-the-money options. A buyer of a strangle becomes long a put and long a call of different strikes. Let’s go back to the options on the September CME E-mini S&P 500 Index futures contract trading at 1,545 on July 6. At that time, the strangle buyer could purchase the September 1,585 call at a premium of 17.5 index points and buy the September 1,505 put for a premium of 26 index points, for a long strangle premium of 43.5 index points (17.5 + 26 = 43.5).
The strangle buyer will profit if the futures index moves above the level of the long call strike of 1,585, plus the total spread premium, which, in this example, is 43.5 points above the long call strike price or 1,628.5. Above this level the strangle becomes profitable. On the downside, the long strangle becomes profitable if the index moves below the put strike price of 1,505 minus the total premium of 43.5, or 1,461.5.
Additionally, both options may increase in value if volatility were to increase substantially. See Figure 3.
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Another possible play exists here. The opposite of a long strangle is a short strangle. See Figure 4. This may be appropriate for an investor who feels that the market is stagnant and is willing to absorb risk if the index moves outside of the breakeven points. In this example, the investor goes short the 1,586 call and short the 1,505 put, receiving a total premium of 43.5 index points. This strategy will be profitable if at expiration, it is within the range of 1,461.5 and 1,628.5.
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Verticals
Earlier we said the beauty of all this is that you do not need a directional bias to trade options on CME E-mini S&P 500 index futures. Though the previous straddle and strangle strategies required the investor to have an up or down bias regarding volatility, using strategies called verticals, horizontals and butterflies do not necessarily require a volatility bias. Vertical spreads involve the purchase of one strike and the sale of another within the same month. See Figure 5.
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A bullish spread, the long call vertical, for example, is the purchase of one at-the-money call option and the sale of an out-of-the-money call within the same month, for a net debit. Using E-mini option prices on July 6 again, the spread buyer purchases the September CME E-mini S&P 500 futures options 1,575 call for 22 index points and simultaneously sells the 1,600 call for a premium of 13 points, for a net debit of nine index points.
If the CME E-mini S&P 500 Index futures moved higher, this spread could expand to a maximum of 25 index points at expiration, which is the difference between the two strikes. If the index closed expired at 1,610 for example, the 1,575 call would be worth 35 index points, the 1,600 call would be 10 points and the spread would be 25 .
If you were bearish on the S&P 500 market, you might consider selling the call vertical with the hope of retaining the spread credit received, and the spread would lose value if the index moved below your breakeven level. Investors can also trade put verticals, which move in the opposite direction as the same strike call verticals, since puts move in the opposite direction as calls. A bullish put vertical would require selling the spread. A bearish put vertical would require buying the vertical put spread.
Just the Tip of the Iceberg
There are still other possible paths you can take. Horizontal spreads involve the purchase of one strike price and the sale of an identical strike with a different expiration month. Butterfly spreads involve the purchase of two separate strikes and the sale of twice as many options at an exercise price between the two long strikes. The horizontal spread is used to profit from option price movement, involving the price relationships between the expiration months. The butterfly spread offers the potential to profit from option price movement between strikes, which varies with their relationship to the closing prices at expiration.
Making this even easier is a new piece of technology called “user-defined spreads.” When you trade options spreads on CME E-mini equity index futures, investors can execute multileg strategies, trading up to 40 different option legs and up to two futures contracts simultaneously on CME Globex. In other words, you have the ability to choose the legs of a spread if the spread is not identified by CME already. We covered a lot of ground here. Essentially, these options spreading strategies are a nice way to try to benefit from your ideas on market direction and volatility.
