Section 1 - Introduction to Index Options: Essential Terms and Definitions

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Index options are similar to options on individual stocks in many ways. Some
commonly used option terms, however, have slightly different meanings when
applied to index options, so a quick review of these terms is appropriate. First, the
term “index” will be defined. Second, the unique aspects of index options will be
discussed.

An index is a formula, or a consistent method, which measures the change in value

of a group of stocks. The Dow Jones Industrial Average™, the S&P 500® Stock
Index and the Nasdaq-100 Index® are well-known indexes, but there are many others in use both in
this country and abroad. The actual methodology of calculating some index levels can be very
complex and sophisticated, but it is not necessary for an average investor to understand the
mathematics. It is only necessary to be familiar with the relative price behaviors of the index(es) you
follow. For instance, a ten-point change in one index may be considered small or insignificant, but a
10-point move in another index’s level may be considered a major one.

A significant difference between index options and equity options is that the underlying entity for an
index option, a calculated index level, does not really exist. When an equity option is exercised by its
owner, and someone is assigned, shares of underlying stock change hands. However, when an index
option is exercised by its owner only money changes hands, through a process known as cash
settlement .

An index option gives a call or put holder the right to receive a cash payment when he exercises an
in-the-money contract. Sellers of index options, on the other hand, are obligated to make the payment
if an assignment notice is received on a short call or put position. The amount of cash that changes
hands is equal to the option’s in-the-money amount, if any, times the index multiplier.

An index multiplier is the amount by which the quoted price of an option is multiplied to calculate the
option’s total market price. With few exceptions, index options in the U.S. have a multiplier of $100, so
an option quoted at “8.50” would cost a total of $850 (8.50 quoted price x $100 multiplier) not including
commissions. Another application of this $100 multiplier is in determining the underlying value of an
index option contract. In other words, if an index option has a strike price of 150 then the underlying
value of the contract is 150 x $100 = $15,000. Underlying values calculated in this way become
significant when hedging portfolios.

Strike prices of index options are conceptually similar to strike prices of equity options.
They are reference points that determine whether an option contract is currently
in-the-money , at-the-money or out-of-the-money , terms which have the same meaning
for index options as for equity options. Expiration dates for index options are also the
same as for equity contracts - the Saturday following the third Friday of the expiration
month.

Index options can have either American-style or European-style exercise. All equity option contracts
are subject to American-style exercise , so many traders of these options might be unfamiliar with
European-style exercise limitations. American-style exercise means that an option holder may
exercise a long call or put on any business day prior to expiration (within established deadlines).
Options that are subject to European-style exercise , however, may generally be exercised only on
the last business day prior to expiration.

On expiration day, both European-style and American-style index options are subject to automatic
exercise , a process by which The Options Clearing Corporation (OCC) automatically exercises and
assigns all index options that are in-the-money by $0.01 (one cent) or more. After options are
exercised, OCC debits and credits the appropriate funds to brokerage firm accounts; brokerage firms,
in turn, debit or credit their customers’ accounts.

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 Exercise of American-style equity options prior to expiration, so-called “early exercise,”
occurs for rational reasons. These options are generally exercised early under certain
circumstances because of impending dividend payments. Early exercise of American-style
index options is common among professional traders for a different reason - generally in an
attempt to profit from perceived arbitrage opportunities between the prices of stock index
futures and stock index options. These opportunities typically arise when contracts are
deep in-the-money and it is close to expiration.

Options that are exercised/assigned before expiration are subject to standard commissions, just as if
the options were sold or repurchased in the marketplace. Early exercise is not, therefore, a way to
avoid commissions and other transaction charges.

Two terms used in considering the settlement of index options are “exercise settlement value” and
“exercise settlement amount.” Exercise settlement value is the level of the underlying index that is
used to determine how much cash changes hands upon exercise of an in-the-money option contract.
This cash amount is the difference between the option’s strike price and the underlying index’s
exercise settlement value on the day of exercise, and is referred to as the “exercise settlement
amount.” Cash is paid to the option holder who exercises an in-the-money call or put contract by the
option seller who is assigned on a similar short position. An index’s settlement value may be
determined by one of two methods. One, based on closing stock prices, is known at “PM settlement.”
The other, based on opening prices, is known as “AM settlement.”

With PM settlement, also known as “afternoon settlement,” an index’s exercise settlement value is
based on the day’s disseminated closing level of the underlying index, which is calculated from the
closing prices of all of the index’s component stocks. Cash payments and receipts from exercise and
assignment are based on this index level on the day of exercise.

AM settlement, also known as “morning settlement,” applies mainly to European-style index option
classes. Generally speaking, these contracts last trade on the Thursday immediately before their
expiration, and may be exercised only on the next day, or Friday. The index’s exercise settlement
value is determined on this Friday morning, and is based on the opening prices of all the index’s
component stocks. When opening prices of all stocks have been established, the index’s settlement
value is calculated and disseminated. Cash payments and receipts from exercise and assignment are
based on this index level on the only day of exercise, or Friday before expiration. You should be aware
that on some expiration Fridays the exercise settlement values of some indexes can be delayed for
several hours due to delayed openings of individual stocks.

Disseminated exercise settlement values for index options subject to AM settlement

have their own ticker symbols. For example, the ticker symbol for the settlement
value of DJX Index options, options on the Dow Jones Industrial Average, is “DJS.”
For NDX options, options on the Nasdaq-100 Index, the settlement value is “NDS”.

Section 2 - Contract Specifications for Options on Various Indexes

Index options began trading in 1983 at the Chicago Board Options Exchange, 10 years
after the exchange began trading options on individual stocks. The first class of index
options traded was based on the S&P 100® Index, also known as OEX®. Today at the
CBOE, options are traded on a multitude of underlying indexes. This section will present
a brief overview of the contract specifications of some of the most popular.

Underlying Index
A particular class of index options may or may not be based on the full level of the underlying index.
For instance, options based on the Dow Jones Industrial Average have DJX as their underlying, and
DJX is calculated as 1/100th of the current level of the Dow. Therefore, if the Dow Jones Industrial

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 Average were currently trading at a level of 9,500, then DJX would be calculated as 95.00 (9,500 ÷
100).

Options on the Nasdaq-100 Index, or NDX, have as their underlying the full NDX index level. If the
Nasdaq-100 Index were 1,500, then NDX underlying these contracts would also be 1,500. A related
class of index options is one based on the Mini-NDX Index, or MNX, which is calculated as 1/10 th the
level of the NDX index. In other words, if the NDX were currently 1,500, then MNX would be calculated
as 150 (1,500 ÷ 10).

Expiration Months
Index option classes may generally have up to six near-term expiration months at any one time, but
will not expire more than twelve months out. There may also be LEAPS ® options with expirations up
to five years away.

Strike Price Intervals

Strike price intervals vary by option class. For instance, strike prices for DJX options are every 1.00,
equivalent to 100 points on the Dow Jones Industrial Average. Options on the Mini-NDX Index (MNX),
however, have strike prices every 2.5 index points, and S&P 500 Index options (SPX) have strike price
intervals of 5 index points.

Exercise Style
Most index option classes traded at CBOE have European-style exercise, and these contracts may
generally be exercised only on the last business day prior to their expiration (a Friday). A notable
exception to this is the OEX option class which is American-style; these contracts may be exercised at
any time prior to their expiration. An index option position, however, may be closed out at any time by
making an offsetting, closing sale or closing purchase transaction in the marketplace.

AM/PM Settlement
Most index option classes at the CBOE, including the popular DJX, SPX, NDX, MNX and RUT options
are subject to AM settlement. Exceptions to this are options based on the S&P 100 Index (OEX and
OEF), which are PM-settled.

Options subject to AM settlement have unique ticker symbols for their disseminated exercise
settlement values. The ticker symbol for the exercise settlement value of SPX options, for example, is
“SET”. The ticker symbol for the exercise settlement value of the Russell 2000® Index is “RLS”.

The following is a list of contract specifications of some of CBOE’s more popular index options:

Index Options Based on the Dow Jones Industrial Average

Symbol of Underlying DJX (1/100th of the Dow Jones Industrial Average) - If the DJIA is 10,750,
Index: the DJX is 107.50
Root Ticker Symbol: DJX
Strike Price Intervals: 1 point (e.g., 104.00, 105.00, 106.00, 107.00, etc.)
Exercise Style: European (early exercise is not permitted)
Generally, up to three near-term months + up to 3 months from the March
Expiration Months:
quarterly cycle
The business day (usually a Thursday) preceding the day on which the
Last Day of Trading:
exercise settlement is calculated
Settlement of Option AM settlement (opening prices on expiration Friday determine index value
Exercise: for cash-settlement transfers)
Ticker Symbol for
Exercise Settlement DJS
Value:

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 Index Options Based on the S&P 500 Index

Symbol of Underlying SPX (full value of the S&P 500 Index) – If the S&P 500 is 1,100, SPX is
Index: 1,100
Root Ticker Symbol: SPX
Strike Price Intervals: 5 points (e.g., 900, 905, 910, 915, etc.) – 25 points for far months
Exercise Style: European (early exercise is not permitted)
Expiration Months: Three near-term months + three months from the March quarterly cycle
The business day (usually a Thursday) preceding the day on which the
Last Day of Trading:
exercise settlement is calculated
AM settlement (opening prices in the primary market of each SPX
Settlement of Option
component stock on Friday preceding expiration determine index value for
Exercise:
cash-settlement transfers)
Ticker Symbol for
Exercise Settlement SET
Value:

Index Options Based on the S&P 100 Index

Symbol of Underlying
OEX (full value of the S&P 100 Index) – If the S&P 100 is 450, OEX is 450
Index:
Root Ticker Symbol: OEX
Strike Price Intervals: 5 points (e.g., 450, 455, 460, 465, etc.) - 10 points in the far-term month
Exercise Style: American (early exercise is permitted)
Expiration Months: Four near-term months + one month from the March quarterly cycle
Last Day of Trading: Third Friday of expiration month
PM settlement (closing prices of OEX component stocks on Friday
Settlement of Option
preceding expiration, or on day exercise notice is properly submitted if
Exercise:
before expiration, determine index value for cash-settlement transfers)
Ticker Symbol for
Exercise Settlement OEX
Value:

Index Options Based on the Nasdaq-100 Index

Symbol of Underlying NDX (full value of the Nasdaq-100 Index) – If the Nasdaq-100 is 950, the
Index: NDX is 950
Root Ticker Symbol: NDX
Strike Price Intervals: 5 points (e.g., 900, 905, 910, 915, etc.)
Exercise Style: European (early exercise is not permitted)
Up to three near-term months + up to three months from the March quarterly
Expiration Months:
cycle
The business day (usually a Thursday) preceding the day on which the
Last Day of Trading:
exercise settlement value is calculated
AM settlement (opening prices in the primary market of each NDX
Settlement of Option
component stock on Friday preceding expiration determine index value for
Exercise:
cash-settlement transfers)
Ticker Symbol for
Exercise Settlement NDS
Value:

Index Options Based on the CBOE Mini-NDX

Symbol of Underlying th
MNX (1/10 of the Nasdaq-100 Index) – If the Nasdaq-100 is 950, the
Index: MNX is 95.00
Root Ticker Symbol: MNX

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 Strike Price Intervals: 2.5 points (e.g., 900.0, 902.5, 905.0, 907.5, 910.0, etc.)
Exercise Style: European (early exercise is not permitted)
Up to three near-term months + up to three months from the March
Expiration Months:
quarterly cycle
The business day (usually a Thursday) preceding the day on which the
Last Day of Trading:
exercise settlement value is calculated
AM settlement (opening prices in the primary market of each NDX
Settlement of Option
component stock on Friday preceding expiration determine index value for
Exercise:
cash-settlement transfers)
Ticker Symbol for
Exercise Settlement XMS
Value:

Index Options Based on the Russell 2000® Index

Symbol of Underlying RUT (full value of Russell 2000 Index) – If the Russell 2000 is 350, the
Index: RUT is 350
Root Ticker Symbol: RUT
Strike Price Intervals: 5 points (e.g., 350, 355, 360, 365, etc.) below 200 – 10 points above 200
Exercise Style: European (early exercise is not permitted)
Three near-term months + three months from the March quarterly cycle -
Expiration Months:
LEAPS with expirations up to five years in the future may be listed
The business day (usually a Thursday) preceding the day on which the
Last Day of Trading:
exercise settlement value is calculated
AM settlement (opening prices in the primary market of each RUT
Settlement of Option
component stock on Friday preceding expiration determine index value for
Exercise:
cash-settlement transfers)
Ticker Symbol for
Exercise Settlement RLS
Value:

Index Options Based on the Mini S&P 500 Stock Index

Symbol of Underlying XSP index (1/10th of the S&P 500) – If the S&P 500 (SPX) is 1,200, the
Index: XSP is 120
Root Ticker Symbol: XSP
Strike Price Intervals: Every 1.00 (e.g., 119, 120, 121, 122, etc.)
Exercise Style: European (early exercise is not permitted)
Up to three near-term months + up to three months from the March
Expiration Months:
quarterly cycle
The business day (usually a Thursday) preceding the day on which the
Last Day of Trading:
exercise settlement value is calculated
AM settlement (opening prices in the primary market of each SPX
Settlement of Option
component stock on Friday preceding expiration determine index value for
Exercise:
cash-settlement transfers)
Ticker Symbol for
Exercise Settlement XSR
Value:

Section 3 - Investor Strategy #1: A Conservative Way of Investing in an S&P 500

Index Fund
Buying stock is perhaps the most basic investment-oriented strategy there is.
Another basic strategy, however, is purchasing index mutual funds. An index

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 mutual fund attempts to match the performance of a particular index by purchasing
its component stocks in proper proportion

Just as call options on individual stocks can be used to limit the risk of purchasing
underlying shares, so can index calls be used to limit the risk of purchasing index
mutual funds. Here’s an example of how it works.

Assume Linda is a conservative investor who has money to invest in an S&P 500 Index mutual fund.
However, add this twist: On the one hand Linda wants to invest, but on the other hand she is worried
about the short-term market outlook. Everything she reads suggests that the market might be headed
for a 10-15% decline. While such concerns have not been justified in the past, maybe this is the time!
If she waits, she could find herself investing at a higher index level in the future. If she invests now and
the market declines, then her capital will suffer along with the market. Can Linda get exposure to the
market now and protect herself at the same time? The answer is a resounding, “Yes!”

The concept of what Linda can do is simple; it involves two steps. First, Linda can
deposit most of her investment capital in a money market fund for the short term, and at
the same time she can buy SPX Index call options on a dollar-for-dollar basis with the
cash in the money market fund. Second, at option expiration she can make her
investment in the S&P 500 Index fund. If the S&P 500 has risen as she hoped, Linda can exercise her
calls, add the cash received to her money market funds, and purchase approximately the same
number of S&P 500 Index fund units that she could have purchased initially. On the other hand, if the
S&P 500 has declined as she feared then Linda’s calls would expire worthless, but her money market
funds would not have declined with the market. At that point it may be possible for her to purchase
more units of the S&P 500 Index fund than she could have purchased initially. Consider the following
example.

Assume Linda has $94,000 to invest in an S&P 500 Index fund, and that the S&P 500 Index is
currently at 900. Assume also that a 90-day SPX 900 Call is trading at a quoted price of 40, or a total
of $4,000 ($40 x $100 multiplier) not including commissions. Linda'’s first step is to deposit $90,000 in
a money market fund. Second, she can purchase one SPX 90-day 900 Call with the remaining $4,000
of her investment capital.

Why one SPX call? Remember that the index multiplier is $100, and that this multiplier
tells us two things. First, it tells us that the quoted option price of “40” translates into an
actual market price of $4,000 (40 x $100 multiplier). Second, it tells us that the
underlying notional value of the 900-strike call is $90,000 (900 x $100 multiplier). This
means that if the SPX Index is above 900 at expiration then a 900 Call will perform like
$90,000 invested in the index, less the call’s initial cost. Let’s see what would happen to Linda if the
S&P 500 Index (SPX) either rises or declines.

If the SPX rises to a level of 1,000 at option expiration, then $90,000, if it had been invested in an S&P
500 index fund, would increase to $100,000.

Now consider Linda’s SPX 900 Call. With the SPX Index at 1,000 at expiration, the Call will be worth
$100 (1,000 index level – 900 strike price) or a total of $10,000. Her profit, however, would be $6,000
because the call initially cost $4,000. If Linda exercises the in-the-money call and adds the $10,000
cash received to her money market funds of $90,000, then she will have $100,000 to invest in an S&P
500 fund. This is the same position she would have if she had invested $90,000 in the S&P 500 fund
initially. It is, of course, less than she would have if she had originally invested all of her $94,000 in the
fund.

Consider what would happen if the SPX instead falls to 800 at expiration. Her $90,000,
if it had been invested in the index fund at 900, would decline to $80,000, a decrease
of $10,000.

With the SPX at 800 at expiration, Linda's 900 Call will expire worthless for a loss of $4,000. But

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 Linda's money market fund balance of $90,000 would remain intact. She could, therefore, invest her
$90,000 in the S&P 500 fund at the current index level of 800 and have a larger position than if she
had invested $90,000 initially.

The following profit/loss table and profit/loss diagram illustrate how buying a call and investing in a
money market fund compares to investing in the S&P 500 Index fund.

Profit/Loss Table

Buy SPX 900 Call & Invest in Money Market Fund

Compared to
Buy S&P 500 (SPX) Index Fund

SPX Index S&P 500 Index Profit/Loss SPX 900 Call SPX 900 Call
at Fund from Purchased at 40 +
Expiration Purchased at Money Market (Profit/Loss) Money Market
Index Level of (Ignore interest (Total
900 for simplicity) Profit/Loss)
(Profit/Loss)

1050 +15,000 0 +11,000 +11,000

1000 +10,000 0 +6,000 +6,000

950 +5,000 0 +1,000 +1,000

900 0 0 -4,000 -4,000

850 -5,000 0 -4,000 -4,000

800 -10,000 0 -4,000 -4,000

750 -15,000 0 -4,000 -4,000

Profit/Loss Diagram

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 The table and diagram show what happens at expiration if the SPX Index is above 900, below 900, or
equal to 900. If the index is above 900, then Linda’s call has value. At that point she can exercise the
call and invest the cash received along with the balance in the money market fund in a S&P 500 Index
fund.

If the index level is below 900, then Linda’s call will expire worthless, but her money market funds will
not have declined. At that point she can invest in the S&P 500 Index fund at that lower level and,
perhaps, purchase more units than she could have purchased initially.

How should Linda think when considering the strategy of buying an index call combined
with a money market fund investment? She must think about risk. Is she so confident
that she wants to invest in an index fund right now and live with the risk that that
decision entails? Or is she willing to pay the cost of the call which will make less if the
market rises, but also limit risk if the market declines. This is a subjective decision that only Linda can
make.

A Variation on the "Buy Index Call and Money Market" Strategy

In the Investment Oriented Strategies Course we discussed a technique of
long-term investing that involves making steady, consistent investments.
Regardless of the amount, regular savings will accumulate over time. If you are
a regular saver or perhaps make regular investments in index funds, then index
call options can provide you benefits similar to to those for an investor in
individual stocks.

A weekly savings of $100 amounts to approximately $10,000 over a 2-year

period. The purchase of an index call option today makes it possible to start
controlling an investment of approximately that size right now. In two years, if the index is higher, you
can actually invest in the index fund at the strike price of the call which is close to today’s index level. If
the index is lower, your call will expire worthless, but your hard-earned savings will not have decreased
in value.

The strategy that targets this goal for individual stocks is "Buy Long-Term Call now and Start Saving."
The same strategy using long-term index calls can also be used for investing in index mutual funds.

Consider the situation of an investor named Sue who has $800 now and saves $100 per week. Sue
does not have $10,000 to invest in a Dow Jones Industrial Average index fund at the moment, but if
the DJX Index is currently 100, equal to 10,000 on the DJIA, and a 2-year DJX 100 Call is trading for
8, then the index options market has given Sue an alternative that she would not otherwise have.

If Sue purchases one 2-year DJX 100 Call today, then she will have the right to receive
the in-the-money amount on the expiration date in two years. If she also saves $100 per
week for 2 years, then she will have approximately $10,000 at the option expiration
date. If the DJX Index level is above 100 and if Sue still wants to invest in the index
fund, then she can exercise her 100 Call and invest the cash received along with the
money market funds in a DJIA Index mutual fund. If she does this, she will have nearly
the same position she would have if she invested $10,000 today.

Alternatively, if Sue decides that she no longer wants to invest in the index fund, then she can sell her
call in the market at the prevailing price and use the funds received as she chooses. She will also have
the accumulated funds in the money market account.

If the DJX Index level is at or below 100 at option expiration, then Sue’s 100 Call will
expire worthless for a loss of $800 plus commissions. However, she will still have the

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 accumulated funds in her money market account, and she will still have two choices:
she can invest in the index fund at the lower index level, or she can invest her
accumulated funds elsewhere.

Section 4 - Investor strategy #2: Protecting a Portfolio

In the previous section we discussed how a conservative investor with cash
or cash-like investments might use index call options to enter the market
with limited risk. Now consider how an investor in a different situation might
use index put options to limit risk. This investor is fully invested in either
index funds or a diversified portfolio that follows an index on which options
are traded.

Consider the case of Michelle who has $40,000 invested in a Russell 2000
(RUT) Index fund because she thinks that small-capitalization stocks will
perform well in the next two quarters. Nevertheless, she is a little nervous. If
the RUT Index is 400, and if 6-month RUT 400 Puts are trading for 25, or
$2,500 total (25 x $100 multiplier), then Michelle can protect her Russell Index fund investment by
purchasing one of these puts. This strategy will limit the risk of owning the index fund until the option
expiration date in 6 months. Let’s see how this strategy works.

As in the previous examples, we will first describe the strategy. Second, we will draw a profit and loss
diagram . Third, we will examine what happens if the Russell 2000 Index is higher, lower or unchanged
at option expiration. And, fourth, we will discuss how Michelle might think about using this strategy.

The strategy that Michelle is considering is:

Own Russell 2000 (RUT) Index Fund @ $400 = $40,000

Buy 1 6-month RUT Put @ $25 each = 2,500

For this particular position the profit/loss table and profit/loss diagram look like these:

$40,000 Invested in RUT Index fund at 400 and

Long 1 RUT 400 Put at $25

RUT Index RUT Index Fund RUT 400 Put Total

at Purchased at 400 Purchased at $25 Profit/Loss
Expiration (Profit/Loss) (Profit/Loss)

480 + 8,000 - 2,500 + 5,500

460 + 6,000 - 2,500 + 3,500

440 + 4,000 - 2,500 + 1,500

420 + 2,000 - 2,500 - 500

400 0 - 2,500 - 2,500

380 - 2,000 - 500 - 2,500

360 - 4,000 + 1,500 - 2,500

340 - 6,000 + 3,500 - 2,500

320 - 8,000 + 5,500 - 2,500

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 The diagram and the table together show what happens if the RUT Index level is above 400, below
400 or at 400 at option expiration. If the RUT index level is at or above 400, then the 400 Put expires
worthless. Michelle, of course, will still have her investment in the RUT Index fund which, with the
index at or above 400, is worth at least the $40,000 she initially paid. Above an index level of 425,
Michelle will have a net profit, because the rise in portfolio value will offset the cost of her puts.

Between index levels of 400 and 425, Michelle will have a loss, and hindsight might
tell her that she should not have purchased the puts. But Michelle should remember
that, because of her fear of a market decline when the puts were purchased, it was
the insurance the puts provided that kept her in the market. Otherwise, she may have
liquidated her index fund position and “gone to cash.”

If the RUT Index is below 400 at expiration, then Michelle’s put will have value, and she will receive
cash when she sells or exercises it. That cash will at least partially offset the decline in her index fund
investment. If, for example, the RUT Index declines to 340 at expiration, Michelle’s $40,00 investment
will decline to $34,000 for a $6,000 loss. In this case, however, Michelle's RUT 400 Put will have
increased to 60, or $6,000 total, and she will have a profit of $3,500 on the put. This profit is calculated
by subtracting the purchase price of 25, or $2,500 total, from the value of 60 (400-340), or $6,000 total,
at expiration. This profit partially offsets the loss of $6,000 on her Russell 2000 Index fund investment.

What should Michelle focus on when considering the purchase of index puts for
portfolio protection? The crucial element is her perception of risk. She should not
purchase puts for protection if she is confident that the RUT Index will rise. She
should purchase these puts only if her perception of risk justifies the cost. Purchasing
puts involves a trade-off. In return for paying a premium, Michelle will limit her loss
potential during the life of the put. The decision to buy a put for protection is subjective, and only
Michelle can make it.

Section 5: Unique Aspects of Index Option Price Behavior

The following section is fairly technical, so prepare yourself.

In theory, trading index options is the same as trading options on individual stocks. In practice,
however, there some differences.

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 One big difference is that the implied volatility level of index options changes noticeably and frequently.
Implied volatility, remember, is the volatility percentage which, if used in an option pricing formula,
returns the current market price of the option as the theoretical value. Consider the following example.

Debra was bullish on the OEX Index, so she purchased a OEX 510 Call at 12.30 in an attempt to profit
from her forecast. The index rose as much as she predicted and within the time period she expected,
but the price of the call declined to 11.80! Debra was understandably frustrated, so let’s see how this
could happen.

When Debra made her forecast, the OEX Index was at 500. It was 60 days before
option expiration, interest rates were 3% and the dividend yield was 1.5%. Given these
factors and a price of 12.30, the Options Calculator was used to determine that the
implied volatility of the OEX 510 Call was 20%. This is how that determination was
made:

Calculating the implied volatility of Debra’s OEX 510 Call

Calculator Inputs

Index Price: 500

Strike Price: 510

Volatility:
20%
(as an Output)
Annual Interest Rates: 3.0%
Annual Dividend Yield: 1.5%
Days to Expiration: 60
Market Price of 510 Call:
12.30
(as an Input for Volatility)

Debra’s forecast was for the OEX to rise 10 points to 510 in 10 days, and she used the Options
Calculator, as illustrated below, to estimate that her 510 Call would rise to 15.55.

Debra’s forecast for the OEX 510 Call Original Inputs New Inputs

Index Price: 500 510

Strike Price: 510 510

Volatility: 20% 20%
Annual Interest Rates: 3.0% 3.0%
Annual Dividend Yield: 1.5% 1.5%
Days to Expiration: 60 50

Estimated Option Price of 510 Call: 12.30 15.55

The index rose to 510 in 10 days as Debra forecast, but, as stated above, the price of the 510 Call
decreased from 12.30 to 11.80 !! Debra wants to know what has changed, that could have caused
the price of her OEX 510 Call to drop?

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 Since interest rates, dividends and the strike price are all observable, changes in these factors would
be known. The unaccounted for factor was a change in the call’s implied volatility. It logically follows
that under these circumstances since the change in option price was a decrease, then implied volatility
must have decreased. The Options Calculator can be used to prove so, and to determine by how
much.

Calculating the new implied volatility of the OEX 510 Call

Calculator Inputs

Index Price: 510

Strike Price: 510

Volatility:
15%
( as an Output)
Annual Interest Rates: 3.0%
Annual Dividend Yield: 1.5%
Days to Expiration: 50
Price of OEX 510 Call:
11.80
(as an Input for Volatility)

The conclusion is that as the OEX Index level rose over five days from 500 to 510, the implied volatility
of the OEX 510 Call decreased from 20% to 15%. The combination of three factors, increase in index
level, decrease in days to expiration and decrease in implied volatility, caused the price of the OEX
510 Call to decrease from 12.30 to 11.80. Debra accurately forecasted two of the factors, but, when
trading index options, you need all three.

A Three-Part Forecast is Required

Index options are frequently difficult for beginners to trade, because the task of forecasting
has changed from forecasting two components, price and time, to forecasting three
components, price, time and implied volatility.

The task of adding time to a price forecast is difficult enough, but for people who enjoy
trading options that adjustment seems possible. After all, if you have traded stocks, then
you are accustomed to forecasting price. Adding a second factor, time, is probably not an
insurmountable task.

But adding a forecast for implied volatility? That is something different. First, the concept of implied
volatility is new to most people, including experienced stock traders. Second, it takes quite a while to
become comfortable with the concept of implied volatility. Third, it takes an equally long time to
develop a feel for how much implied volatility can change and what impact a given change can have
on an option position’s profitability. One way to develop a feel for this is to study past implied volatility
levels for contracts of any option class before making a purchase or sale in the marketplace.

Section 6: Reducing the Risk of Changes in Implied Volatility

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 Since change in implied volatility is a risk for option traders, it is logical
to ask, "How can I reduce this risk?" The answer is to trade spreads.

Option spreads are multiple-part positions involving at least one long

(purchased) option and at least one short (sold) option. In this section
you will be introduced to a two-option spread known as a bull call
spread. A bull call spread, one type of vertical spread, is created by purchasing one call and
simultaneously selling a second call with the same expiration month but with a higher strike price.
There are also bearish call spreads and bullish and bearish put spreads. Space does not permit a
complete discussion of all these strategies, but the concepts discussed here involving bull call spreads
also apply to the other three types of spreads.

Referring back to our previous scenario, let’s see how Debra might have used a call spread to profit
from her forecast that the S&P 100 Index (OEX) would rise. When Debra was initially looking at the
OEX 510 Call, other calls with different strike prices were also available. Let’s see what some of
Debra’s other choices were:

Strike Price Price Implied Volatility

OEX 490 Call 21.50 19.12%

OEX 495 Call 19.00 19.58%

OEX 500 Call 16.75 20.01%

OEX 505 Call 14.50 20.13%

OEX 510 Call 12.30 20.01%

OEX 515 Call 10.50 20.11%

OEX 520 Call 9.00 20.32%

OEX 525 Call 7.75 20.62%

Assumptions:
Index Level = 500
Interest Rate = 3.0%
Annual Dividend Yield = 1.5%
Days to Expiration = 60

Given 20-20 hindsight, even though Debra was bullish on the OEX she may have been reluctant to
purchase her 510 Call if she had been aware of its relatively high implied volatility of 20%. Volatility
levels for OEX options had been in the 10% to 15% range for some time. Of course, after she
purchased her call its implied volatility level, instead of decreasing, could just as easily have increased
above the current level of 20% and the outcome of her position been profitable.

Note that relative high and low levels of implied volatility vary depending on the underlying entity. For
instance, implied volatility of options on certain underlying stocks might typically remain around 50% to
60% or higher, while for other stocks it may be lower at 30% to 40% or lower. However, as a rule the
implied volatility for broad-based index options is typically lower than for individual equity option
classes. Whether trading equity or index options, traders should develop a familiarity with implied
volatility levels in the past for any class of options they trade so they can develop good judgment as to
whether current volatility is high or low relative to past levels.

Let’s see how a bull call spread might have been helpful in Debra’s situation.

With the prices listed in the table above, Debra could have established a 490-500
Bull Call Spread by simultaneously buying one 490 Call at 21.50 and selling one 500
Call at 16.75. The net cost, therefore, would have been 4.75, or $475 per spread not
including commissions. The profit/ loss table and profit/loss diagram on the next
page show how this position performs at expiration. Although Debra’s time forecast

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 is 10 days and not 60 days which is option expiration, the table and diagram are
useful starting points. They show the maximum profit potential, maximum risk and break-even point at
expiration. After we understand the bull call spread from this perspective, then we will compare the two
strategies over Debra’s 10-day time horizon.

Profit/ Loss Table

OEX 510 Call Purchased @12.30

Compared to
OEX 490-500 Call Spread Purchased @4.75

Call Spread 510 Call

Value of
OEX Index at Value of Value of Profit/Loss Value of Profit/Loss
490-500
Expiration 490 Call 500 Call at 510 Call at
Spread
Expiration Expiration
530 40 30 10 +5.25 20 +7.70
525 35 25 10 +5.25 15 +2.70
520 30 20 10 +5.25 10 -2.30
515 25 15 10 +5.25 5 -7.30
510 20 10 10 +5.25 0 -12.30
505 15 5 10 +5.25 0 -12.30
500 10 0 10 +5.25 0 -12.30
495 5 0 5 +0.25 0 -12.30
490 0 0 0 -4.75 0 -12.30

485 0 0 0 -4.75 0 -12.30

The profit/loss table and profit/loss diagrams above show how the 490-500 Bull Call Spread compares
to the long 510 Call at expiration. The long 510 Call has unlimited profit potential, maximum risk of
12.30 and a break-even point of 522.30 at expiration. In comparison, the 490-500 Bull Call Spread has
a maximum profit potential of 5.25, a maximum risk of 4.75 and a break-even point of 494.75 at
expiration.

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 You should note that the maximum profit potential of a bull call spread is equal to the
difference between the strike prices less the spread’s net cost. In this example, the
difference between the strikes is 10 (500 - 490), the cost of the spread is 4.75 (21.50 -
16.75), and so the maximum profit potential is 5.25 (10 - 4.75). Also, note that the
maximum profit potential is realized at expiration if the underlying index is at or above
the higher strike, or 500 in this example.

Recognizing the Trade-Offs

Which is “better,” a simple long call or a bull call spread?
Unfortunately, there is no “better” in an absolute sense. Each strategy
has a different set of advantages and disadvantages. The bull call
spread has a lower cost than the 510 Call, a lower break-even point
at expiration and a limited profit potential. The “limited profit potential”
aspect may bother some traders who worry that, if a very large move
in their direction does occur they will not be able to fully participate.
This is a valid observation. But as the table and diagram indicate, the
490-500 Bull Call Spread performs better in some scenarios (lower
OEX levels), while the long 510 Call performs better in others (higher
OEX levels).

The question is, given Debra’s 10-day forecast, why should she
consider purchasing the 490-500 call spread as an alternative to
purchasing the 510 call? To answer this question let’s recall the
concept of a three-part forecast introduced in the last section. Debra, remember, predicted that the
OEX Index would rise from 500 at 60 days prior to expiration to 510 at 50 days. Debra’s forecast did
not, however, include a forecast for the level of her option’s implied volatility.

A beginner, of course might feel unsure about making a forecast for implied volatility, so let’s consider
three possibilities over Debra’s 10-day timeframe: volatility increases to 25%; volatility remains
unchanged at a level of approximately 20%; and volatility decreases to 15%. Review the table exhibits
below; it shows calculations from the Options Calculator using Debra’s 2-part forecast (timeframe and
index level increase) plus possible changes in the level of implied volatility, which she originally
ignored.

Scenario: Implied Volatility Rises Implied Volatility Implied Volatility

to Remains at Decreases to
Approximately 25% Approximately 20% Approximately 15%
Over 10 Days Over 10 Days Over 10 Days

Estimated Value of 490 Call 30.76 27.53 24.56

Estimated Value of 500 Call 24.61 21.02 17.52

Estimated Value of 490-500
6.15 6.51 7.04
Call Spread
Estimated Value of 510 Call 19.30 15.55 11.80

Assumptions:
Index Level = Rises from 500 to 510
Timeframe = 10 Days (from 60 to 50 days to expiration)
Interest Rate = 3.0%
Annual Dividend Yield = 1.5%

Comparing the results

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 The previous profit/loss table shows that the values of the OEX 510 Call and the OEX 490-500 Call
Spread behave differently as implied volatility changes, given a specific increase in index level and
timeframe. The value of the 510 Call ranges from 19.30 to 11.80 as the implied volatility level
decreases from 25% to 15%. The value of the 490-500 Call spread, however, ranges from only 6.15 to
7.04.

The profit/loss table below compares the price behavior and the profit/loss results of Debra’s two
alternative bullish strategies. It summarizes both the financial advantages and disadvantages of a bull
call spread relative to a simple long call over 10 days and with changing implied volatility levels.

Implied Volatility Forcast Over 10 Value of 510 Call Value of OEX 490-500 Call
Days OEX 510 Profit/Loss 490-500 Spread
Call (12.30 purchase) Call Spread Profit/Loss
(4.75 purchase)
Decreases to 15% 11.80 -0.50 7.04 +2.29
Remains at 20% 15.55 +3.25 6.51 +1.76
Increases to 25% 19.30 +7.00 6.15 +1.40

Assumptions:
Index Level = Rises from 500 to 510
Days to Expiration = 50
Interest Rate = 3.0%
Annual Dividend Yield = 1.5%

If you’re concerned about volatility, a primary benefit of the bull call spread is that it is less sensitive to
changes in implied levels. This is because you are long one call and short another, and so the effects
of changing implied volatility levels for the two options tend to offset one another. In return for less
volatility risk is, of course, the spread’s limited profit potential. Another benefit of the spread is that it
cost less to establish than the simple long call position, and its potential loss is limited to the smaller
premium paid.

The simple long call position also has a limited loss potential, though more possible loss than the
spread because it cost more to establish. However, it has unlimited profit potential as long as the OEX
index level continues to increase. With respect to changing implied volatility levels, as with any long
option position it is vulnerable to decreases and benefits from increases.

On a practical note, the simple long call position involves only one transaction to establish, a buy, and
so just one commission; the spread involves two, a buy and a sell, and generally costs two
commissions. And if you’re entering limit prices, a simple buy order might be easier to execute than a
spread.

Summary of Call Spreads

As you have seen in our examples, the value of a bull call spread can behave
differently from the value of a simple long call position when the underlying index
level increases as expected. If you are looking for protection from unexpected
implied volatility shifts, especially in a very volatile marketplace, then a bull call
spread might be a strategy to consider. If you happen to be bearish, then you might
investigate a bear put spread as an alternative to a simple put position. Just do the
math in advance, as we have done here, to test the possible outcomes with varying
implied volatility levels over your timeframe for your projected decline in underlying index level.
Spreads are not “better” in an absolute sense than simple long option positions; each strategy has
advantages and disadvantages relative to the other.

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