480 Part IV: Additional Considerations
One method of determination involves estimating the liquidating value of the spread
at successive stock prices. When the liquidating value is found to be equal to the ini
tial value, plus commissions, abreak-even point has been located.
Example: If the spread in question is using options with astriking price of 30, one
would begin his break-even point calculations at aprice of 30. Estimate the liquidat
ing value of the spread at 30, 297/s, 29¾, 29-5/s, and so forth until the break-even point
is found. Once the downside break-even point has been determined in this manner,
the iterations to locate the upside break-even point should begin again at the striking
price. Thus, one would evaluate the liquidating value at 30, 301/s, 30¼, and so on. This
is somewhat of abrute-force method, but with acomputer it is fairly fast. The num
ber of calculations can be reduced by adopting amore complicated iteration process.
Afinal useful piece of information can be obtained with the aid of the pricing
model - the theoretical value of the spread. Recompute the estimated value of both
the near-term and longer-term calls at the current time and stock price, using the
implied volatility for the underlying stock. The resultant differential between the two
estimated call prices may differ substantially from the actual differential, perhaps
highlighting an attractive calendar spread situation. One would want to establish
spreads in which the theoretical differential is greater than the actual differential
(that is, he would want to buy a "cheap" calendar spread).
Once these pieces of information have been computed, the strategist can rank
the spread possibilities by whatever criterion he finds most workable. The logical
method of ranking the spreads is by their return if unchanged. The spreads with the
highest return if unchanged at near-term expiration are those in which the stock price
and striking price were close together initially, abasic requirement of the neutral cal
endar spread. More complicated ranking systems should tty to include the theoreti
cal value of the spread and possibly even the maximum potential of the spread. Asimilar analysis can, of course, be worked out for put calendar spreads, using the
arbitrage pricing model for puts.
RATIO STRATEGIES
Ratio strategies involve selling naked options. Therefore, the strategist has potential
ly large risk, either to the upside or to the downside or both. He should attempt to
get afeeling for how probable this risk is. The formulae for determining the proba
bility of astock being above or below acertain price at some time in the future can
give him these probabilities. For example, in astraddle writing situation, the strate
gist would want to compute such arithmetic quantities as maximum profit potential,
return if unchanged, collateral required at upside break-even point or at upside

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:520


Chapter 28: Mathematical Applications 481
action point (recall that the collateral requirement increases for naked options on an
adverse stock movement), and the break-even points themselves. The probabilities of
being above the upper break-even point at expiration or below the lower break-even
point should be computed as well. Moreover, an expected return analysis could be
performed on the position to determine the general level of profitability of the posi
tion with respect to all other positions of the same type on other stocks. Such an
expected return analysis need not assume that the position is held to expiration. Firm
traders, paying little or no commissions, might be interested in seeing the expected
reswts for aholding period as short as 30 days or less. Public customers might use alonger holding period, on the assumption that they would not trade the position as
readily because of commission costs. Ratio positions should be ranked either by
return if unchanged or by expected return.
The analyses described for calendar spreads and ratio positions should not be
relied upon as gospel. In the proposed forms of analysis, one is projecting future
option prices and stock prices under the assumption that the volatility of the under
lying stock will remain the same. Although this may be true in some cases, there will
also be many times when the volatility of the underlying stock will change during the
life of the position. If the volatility decreases, the projected break-even points for acalendar spread will be too far away from the striking price. Thus, aloss would result
at some prices where the spreader expected to make money. If the volatility increas
es, the expected return of aratio position will drop, because the probabilities of the
stock moving outside the profit range will increase, thereby increasing the probabil
ity ofloss.
The effect of achanging volatility can be counteracted, in theory, by continuing
to monitor the position daily after it has been established. In astraddle write, for
example, if the stock begins to move dramatically, the expected return may become
very low. If this happens, adjustments could be made to the position to improve it.
Such monitoring is difficult to apply in practice for the public customer, because the
commission costs involved in constant position adjustments would mount rapidly.
There is no exact method that would allow for infrequent, periodic adjustments, but
by using afollow-up analysis the public customer may be able to get abetter feeling
for the timing of adjusting aposition. For example, suppose that one initially wrote a
5-point straddle when the stock was at 30. Sometime later, the stock is at 34. The
expected return of writing a 5-point straddle with astrike of 30 when the stock is at
34 could be computed for the shorter time period remaining until expiration. If the
expected return is negative, an adjustment needs to be made. Adopting this form of
adjusting would keep the number of trades to aminimum, but would still allow the
strategist to determine when his position has become improperly balanced. Of
course, the current volatility would be used in making these determinations. Another

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:521


482 Part IV: Additional Considerations
follow-up monitoring technique, using the deltas of the options involved, is present
ed later in this chapter, and has been described several times previously.
FACILITATION OR INSTITUTIONAL BLOCK POSITIONING
In this and the following section, the advantages of using the hedge ratio are outlined.
These strategies are primarily member firm, not public customer, strategies, since
they are best applied in the absence of commission costs. An institutional block trad
er may be able to use options to help him in his positioning, particularly when he is
trying to help aclient in astock transaction.
Suppose that ablock trader wants to make abid for stock to facilitate acus
tomer'ssell order. If he wants some sort of ahedge until he can sell the stock that he
buys, and the stock has listed options, he can sell some options to hedge his stock
position. To determine the quantity of options to sell, he can use the hedge ratio. The
exact formula for the hedge ratio was given earlier in this chapter, in the section on
the Black-Scholes pricing model. It is one of the components of the formula. Simply
stated, the hedge ratio is merely the delta of the option - that is, the amount by which
the option will change in price for small changes in the stock price. By selling the cor
rect number of calls against his stock purchase, the block trader will have aneutral
position. This position would, in theory, neither gain nor lose for small changes in the
stock price. He is therefore buying himself time until he can unwind the position in
the open market.
Example: Atrader buys 10,000 shares of XYZ, and a January 30 call is trading with
ahedge ratio of .50. To have aneutral position, the trader should sell options against
20,000 shares of stock (10,000 divided by .50 equals 20,000). Thus, he should sell 200
of the January 30's. If the hedge ratio is correct - largely afunction of the volatility
estimate of the underlying stock - the trader will have greatly eliminated risk or
reward on the position for small stock movements. Of course, if the block trader
wants to assume some risk, that is adifferent matter. However, for the purposes of
this discussion, the assumption is made that the block trader merely wants to facili
tate the trade in the most risk-free manner possible. In this sample position, if the
stock moves up by 1 point, the option should move up by ½ point. The trader would
make $10,000 on his stock position and would lose $10,000 on his 200 short options
- he has no gain or loss. Once the trader has the neutral position established, he can
then begin to concentrate on unwinding the position.
In actual practice, this hedge ratio may not work exactly, because it tends to
change constantly as the stock price changes. If the trader finds the stock moving

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:522


Chapter 28: Mathematical Applications 483
more than fractionally, he may have to add more calls or buy some in, to maintain aneutral hedge ratio. This would expose him to some risk, but the risk is substantially
smaller than if he had not hedged at all. Of course, there would also be certain cases
in which he would profit by the stock price change. For example, implied volatility
could decrease, making the calls cheaper.
Asimilar hedge can be established by the block trader who sells stock to accom
modate acustomer buy order. He could buy calls in accordance with the hedge ratio,
to set up aneutral position.
This process off acilitation is quite widely practiced, especially by brokerage
houses that are trying to attract the business of the large institutional customer. Since
the introduction of listed call options and their applications for facilitating orders,
many quotes for large blocks of stock have improved considerably. The block trader
(who works for the brokerage house) is willing to make ahigher bid or alower offer
if he can use options to hedge his position. This facilitation with options results in abetter market (higher bid or lower off er) from the point of view of the institutional
customer. Without the availability of such listed options, the block trader would prob
ably make abid or an offer that was substantially away from the prevailing market
price in order to work out of his stock-only position with alessened degree of risk
This would obviously present apoorer market for the institutional customer.
THE NEUTRAL SPREAD
The hedge ratios of two or more options may be used to determine aneutral spread.
This strategy is especially useful to market-makers on the options exchanges who may
want to reduce the risk of options bought or sold in the process of providing apub
lic market. If the hedge ratios of two options are known, the neutral ratio is deter
mined by dividing the two hedge ratios.
Example: An XYZ January 35 has ahedge ratio of .25, and an XYZ January 30 has ahedge ratio of .50, so aneutral ratio would be 2:1 (.50 divided by .25). That is, one
would sell 2 January 35'sagainst one long January 30, or, conversely, would buy 2
January 35'sagainst one short January 30. Thus, amarket-maker who has just bought
50 January 30'sin an effort to provide amarket for apublic seller of that call could
hedge his position by selling 100 January 35's. This should keep his risk small, for
small stock price changes, until he can unwind the position. The ratio for the neutral
spread is not as sensitive to the volatility estimate of the underlying stock as is the
ratio concerning stock and options. This is because the same volatility estimate is
applied to both options, and the resultant ratio for the spread would not tend to
change greatly.

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:523


484 Part IV: Additional Considerations
The risk trader can also use the neutral spread ratio to his advantage. This con
cept was illustrated several times in previous chapters describing ratio writing, ratio
spreads, and straddle writes. Ratio spreads are quite popular with member firm
traders and floor traders. Recall that aratio spread consists of buying options at acer
tain strike, and selling more options further out-of-the-money. The hedge ratios can,
of course, be used by the trader, or by apublic customer, to initially establish aneu
tral position. Perhaps more important, the hedge ratio can also be used as afollow
up action to keep the position neutral after the stock changes in price. This strategy
is the "delta spread" described in Chapter 11.
The risk trader is not attempting to establish the spread with the idea of mini
mizing risk for small stock movements. Rather, he is looking to make aprofit, but
would prefer to remain as neutral as possible on the underlying stock. He is imple
menting arisk strategy that has aneutral outlook on the underlying stock. He is sell
ing much more time value premium than he is buying.
Example: The purchase of 15 January 30 calls and the sale of 30 January 35 calls - aratio call spread - may be aposition taken for profit potential. It would be aneutral
position if the deltas were .60 and .30, for example. This spread would do best if the
stock were at exactly 35 at expiration. However, if the stock rose quickly before expi
ration, the spread ratio would decrease from 2:1 to perhaps 3:2. That is, the neutral
ratio between the January 30 call and the January 35 call should be 3 short January
35'sto 2 long January 30's. If the trader wants to balance his position, he could buy 5
more January 30's, giving him atotal of 20 long versus the 30 short January 35'sthat
he originally sold. Conversely, if the stock dropped in price, the neutral spread ratio
might increase, indicating that more calls should be sold. For example, if this stock
declines, the neutral ratio might be 3:1. In that case, 15 more January 35'scould be
sold, making the position short 45 calls versus 15 long calls, which would produce the
neutral 3:1 ratio.
It would not be proper to adjust the ratio constantly, because the frequent
whipsaw losses on trading movements would wipe out the profit potential of the posi
tion. However, the trader may want to pick out points, in advance, at which he wants
to reevaluate his position before something drastic goes wrong. For example, if the
foregoing spread were established with the stock at aprice of 30, the spreader might
want to readjust at 33 or 27, whichever comes first.
By monitoring the spread using the hedge ratio, the trader may also be able to
discern whether he has established too bullish or too bearish aposition.
Example: The trader starts with the example described above - long 15 January 30
calls and short 30 January 35 calls - when the hedge ratios were .60 and .30, respec-

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:524


Chapter 28: Mathematical Applications 485
tively. Some later time, the stock falls to 27 and the trader needs to reevaluate his
position. The hedge ratios may have become .42 for the January 30 and .14 for the
January 35, indicating that a 3:1 ratio would be neutral (.42/.14 = 3). He now has abullish position, because his 2:1 ratio is less than the neutral 3:1 ratio. It is not manda
tory that the trader act on this information. He may actually be bullish on the stock
at this point and decide to remain with his position. The usefulness of the hedge ratio
is that it allows him to see that his position is bullish, so he can make acorrect judg
ment. Without this knowledge, he might still think his position to be neutral, acriti
cal mistake if he indeed wants to be neutral. If the trader'sratio is greater than the
neutral ratio (2:1 vs. 3:2, for example), he is bearishly positioned.
As afinal point, it should be noted that the ratio can be adjusted by buying or
selling either option.
Example: If the stock falls and it is desired that the ratio be increased to 3:1, one
might sell more January 35'sor might decide to sell out some of his January 30's. Abullish adjustment could be made by buying on either side of the spread in asimilar
manner. In general, one should adjust by selling time premium or buying intrinsic
value. That is, out-of-the-moneys are usually sold and in-the-moneys are usually
bought, when adjusting.
AIDING IN FOLLOW-UP ACTION
The computer can also be an invaluable aid to the strategist in that it can help him
monitor his positions. It is generally necessary for the strategist to have some way of
inputting his positions into an inventory database and also to have some way of iden
tifying different securities that are grouped within the same trading position. Once
this has been done, the computer can simultaneously read pricing data ( either real
time or closing prices) and the inventory database to generate information concern
ing the current status of any position.
Acurrent mark to market (profit and loss) statement is of obvious use in that
the trader can see how he is doing each day. The computer can also easily generate
aset of warning flags that may be of interest to the trader, and could produce alist
summarizing possible positions that need action. In most of the strategies that were
described, it was shown that the strategist should avoid early assignment if at all pos
sible. It is asimple matter for the computer to calculate the remaining time value
premium of any short options, and to warn the trader if there is only asmall amount
of time value premium remaining, perhaps ½ point or less. For similar reasons, the
trader may want to have adaily list of positions that are nearing maturity, perhaps

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:525


486 Part IV: Additional Considerations
with less than Imonth oflife remaining in the options. Aflag indicating an approach
ing ex-dividend date might also be useful for this purpose.
If the trader inputs another piece of information into the database, the com
puter can help him in another follow-up action. In most strategies that were
described, especially those involving uncovered options, the trader wants to take
some sort of follow-up action based on the price movement of the underlying stock.
If the stock rallies too far, he may want to cover short calls or buy other calls as pro
tection. If the stock declines too far, similar maneuvers would apply to put options or
to rolling down short calls. If the trader inputs the stock prices at which he would like
to take action, the computer can monitor each day'sclosing price of the stock and
generate alist of positions that have exceeded their upside or downside action points.
The computer can also do more sophisticated types of position monitoring.
Recall that it was pointed out that the deltas of the options involved in aposition can
be compared to each other to tell whether the position is bullish or bearish. The
Black-Scholes model can be used to calculate the deltas of the options in one'sposi
tions. Then the net position can be determined by the computer, thereby telling the
trader whether his position has become "delta long" (bullish), "delta short" (bearish),
or neutral. If he sees that aposition is bearish and he does not want to be structured
in that way, he can make bullish adjustments. The delta spread and neutral spread
strategies very conveniently lend themselves to such types of follow-up action,
although any of the more complicated straddle writing and protected straddle writ
ing positions can be monitored usefully in this way as well.
The computation for determining whether aposition is net short or net long
generally involves calculating the "equivalent stock position" (ESP). If one owns 10
calls that have adelta of .45, his equivalent stock position from those calls is IO X 100
shares per call x .45 = 450. That is, owning those IO calls is equivalent to owning 450
shares of the underlying stock, according to the delta. All puts and calls can be
reduced to an ESP and can then, of course, be combined with any actual long or
short stock in the position to produce an ESP for the entire strategy. The resultant
ESP for each of the trader'spositions can be printed from the computer along with
the items described above.
Further sophisticated measures can be taken. The computer can generate atable of results at expiration. If so desired, this could be presented as agraph, but that
is not really necessary. Atable suffices quite well, as shown by most of the examples
in this book. Such apicture has meaning only if all options in the position expire at
the same time. If they don't, one may instead want the computer to mmpose atable
of results or agraph at near-term expiration. Thus, in acalendar spread, for example,
one could see what sorts of profitability he would be looking at when it was time to
remove the spread.

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:526


Chapter 28: Mathematical Applications 487
Finally, the computer can compute the expected return of aposition already in
place. This would give amore dynamic picture of the position, and this expected
return is usually for arelatively short time period. That time period might be 30 days,
or the time remaining until expiration, whichever is less. The expected return is cal
culated in much the same manner as the expected return computation described ear
lier in this chapter. First, one uses the stock'svolatility to construct arange of prices
over which to examine the position. Second, one uses the Black-Scholes model to
calculate the values of the various options in the position at that future time and at
the various stock prices. Some of the results should be displayed in table form by the
computer program. The expected profit is computed, as described earlier, by sum
ming the multiples of the probabilities of the stock being at each price by the result
of the position at that price. The expected return is then computed by dividing the
expected profit by the expected investment. Since margin computations can require
involved computer programs, it is sufficient to omit this last step and merely observe
the expected profit. The following example shows how asample position might look
as the computer displays the position itself, the ESP, the profit at expiration, and the
expected profit in 30 days. Acomplex position is assumed, in order that the value of
these analyses can be demonstrated.
Example: The following position exists when XYZ is at 31 ¾. It is essentially aback
spread combined with areverse ratio write. It resembles along straddle in that there
is increased profit potential in either direction if the stock moves far enough by expi
ration. Initially, the computer should display the position and the ESP.
Position Delta ESP
Short 4,500 XYZ 1.00 Short 4,500 shares
Short 100 XYZ April 25 calls 0.89 Short 8, 900 shares
Long 50 XYZ April 30 calls 0.76 Long 3,800 shares
Long 139 XYZ July 30 calls 0.74 Long 10,286 shares
Total ESP Long 686 shares
Total money in position: $163,500 credit
The advantage of using the ESP is that this fairly complex position is reduced to asin
gle number. The entire position is equivalent to being long 686 shares of the com
mon stock. Essentially, this is close to delta-neutral for such alarge position. The next
item that the computer should display is the total credit or debit in the position to
date. With this information, an expiration picture can be drawn if it is applicable. In
this position, since there is amixture of April and July options, astrict expiration pie-

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:527


Chapter 28: Mathematical Applications 489
information on the underlying stock are also necessary. The larger programmable cal
culators can handle calculations such as the Black-Scholes model, computing the
hedge ratio, and determining the probability of astock being above or below acer
tain price at some future time. However, more involved calculations, such as com
puting the implied volatility or determining the expected return of aposition, require
the use of acomputer.
SUMMARY
Two basic mathematical aids have been presented: the pricing model and the ability
to predict the probability of astock'smovement. The hedge ratio and the expected
return analysis are extensions of the basic aids. Any strategy can be evaluated with
these tools. Such an analysis should be able to give the trader or strategist some idea
of the relative attractiveness of establishing the position, and may also aid in making
follow-up adjustments to the position. All the analyses rely heavily on one'sestimate
of the volatility of the underlying stock Using the implied volatility seems to be one
of the best ways to obtain an accurate, current volatility estimate, since it is derived
from the prices in the market itself. The applications presented here are not all-inclu
sive. The strategist who is, or becomes, familiar with the advantages of rigorous math
ematical analysis will be able to construct many other aids for his trading that utilize
the basic mathematics described in this chapter.

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:529


Introduction to Index Option
Products and Futures
Since their introduction in 1981, listed index options have proved to be very popular.
Index options are options whose underlying security is not asingle stock but rather an
index composed of many stocks. These include options on index futures contracts.
Most popular types of cash settlement options are options on indices or subindices. The
strategies employed in trading these options are not substantially different from those
used in trading stock options, with afew notable exceptions. However, the options
themselves tend to be priced differently and to trade differently. It is these differences
between stock options and index options on which we will predominantly concentrate.
Index products - cash-based options, futures-based options, and index futures -
will be the main topic of discussion in this section of the book. We will look at how
indices are constructed, how to use these products to speculate, how to hedge, and
how to spread one index against another. Both futures and options will be used in
these strategies. The discussion of other futures options - currencies, grains, bonds,
etc - will be deferred to alater chapter.
In this chapter, we will be looking at introductory facts about index options and
futures which differentiate them from the equity options that have encompassed the
entire previous part of this book. First, however, we will take an in-depth look at stock
indices and the methods of calculating them. Also in this chapter there will be adis
cussion of futures contracts and how trading them differs from trading stocks and
stock options.
INDICES
Since many cash-based or futures options have an index of stocks underlying the
option, it is useful to understand how indices are calculated, in order that one may
be able to understand how an individual stock'smovement within the index affects
493

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:533


Chapter 29: Introduction to Index Option Products and Futures 497
Thus, if stock Agoes up by one point, then the value of the index would increase
by 1.20 points since there are 1.2 shares of stock Ain the index. One can see the value
of computing such astatistic - it readily allows him to see how any individual stock'smovement will affect the index movement during atrading day. This is especially use
ful when astock is halted, but the index itself keeps trading.
Example: Suppose that, in the above index, stock Chas halted trading. There are
0.68 shares of stock Cin the index. Suppose that stock Cis indicated 3 points lower,
but that the index is currently trading unchanged from the previous night'sclose due
to the fact that both stocks Aand Bare unchanged on the day. If one were to try to
price the options on the index, he would be wrong to use the current price of the
index since that will soon change when stock Copens. However, there is not really aproblem since one can readily see that if stock Copens 3 points lower, then the index
will drop by 2.04 points (3 x 0.68). Thus one should price the options as if the index
were already trading about 2 points lower. This kind of anticipation depends, of
course, on knowing the number of shares of stock Cin the index.
Asimilar type of analysis is useful when trying to predict longer-term effects of
astock on an index. If you thought stock Chad achance of rallying 30 points, then
one can see that this would cause the index to rise over 20 points. Given this type of
relationship, there are sometimes option spreads between the stock'soptions and the
index'soptions that will be profitable based on such an assumption.
It should also be noted that the number of shares of stock in acapitalization
weighted index does not change on adaily basis since it does not depend on the price
of the stocks in the index. However, the percent that each stock comprises of the index
does change each day as prices change. Thus, the number of shares is amore stable
statistic to keep track of, and is also more directly usable to anticipate index value
changes as stock prices change.
Capitalization-weighted indices are the most prevalent type, and most investors
are familiar with several of them: the Standard and Poor's 500, the Standard and
Poor's 400, the Standard and Poor's 100 (also called by its quote symbol, OEX), the
New York Stock Exchange Index, and the American Stock Exchange Index.
PRICE-WEIGHTED INDICES
Aprice-weighted index contains an equal number of shares of each stock in the index.
Aprice-weighted index is computed by adding together the prices of the various
stocks in the index and then dividing that sum by the divisor to produce the index
value. Again, the divisor is initially an arbitrary number that is used to produce adesired original index value-something like 100.00, for example. Let us use the same

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:537


500 Part V: Index Options and Futures
of IBM, one might figure that capitalization-weighted indices that contained that
stock would also be showing somewhat unusual price changes in the same direction
that IBM is moving. Aprice-weighted index that contained IBM would, of course,
also be affected by IBM'sprice change, but not extraordinarily so since IBM would
have far less weight in the price-weighted index.
SECTORS
Sector is aterm used to refer to an index of stocks in which all the stocks are mem
bers of the same industry group. Examples of groups on which sectors have been cre
ated - and on which options have traded - are computers and technology, interna
tional oils, domestic oils, gold, transportation, airlines, and gaming and hotels. These
indices are computed in the same ways as described above - either price-weighted
or capitalization-weighted. They generally consist of fewer stocks than their major
counterparts, however. Most sectors are comprised of between 20 and 30 stocks,
since that is about all of the stocks in any one specific industry group. The large
indices are usually referred to as "broad-based" indices, as opposed to the smaller
sectors which are often referred to as "narrow-based" indices.
Options trade on these sectors. The intent of these options is to allow portfolio
managers -who often are group-oriented- to be able to hedge off parts of their port
folio by industry group. The options on these sectors are usually cash-based options.
Strategies will be discussed later, but there is not much difference in strategy
between broad-based or narrow-based index options. One difference is that broad
based option writers receive more favorable margin treatment ( that is, they are
required to put up less collateral) than narrow-based option writers.
CASH-BASED OPTIONS
Now that the reader is familiar with indices, let us look at the most popular type of
listed index option, the cash-based option.
Cash-based options do not have any physical entity underlying the option con
tract. Rather, if the option is exercised or assigned, the settlement is done with cash
only - there is no equity involved. This type of option is generally issued on an index,
such as the S&P 500, for which it would be virtually impossible to actually deliver the
underlying securities in case of assignment or exercise.
Since many investors feel that it is easier to predict the market'smovement
rather than that of an individual stock, the cash-based index option has become very
popular. Other indices that underlie cash-based option contracts are the New York
Stock Exchange Index, the S&P 500 Index, the S&P 100 Index (OEX - an index

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:540


Chapter 29: lntrodudion to Index Option Produds and Futures S01
introduced by the CBOE), the NASDAQ Index ($NDX), the Dow-Jones 30
Industrials ($DIX), and several other indices. In each of these cases there are too
many stocks in the index, and too many varying quantities of each of the stocks, to be
able to handle the physical delivery of each of the stocks in the case of exercise or
assignment. Some cash-based options are based on subindices ( that is, subgroups of
the larger indices such as the transportation group).
EXERCISE AND ASSIGNMENT
It is important to understand the ramifications of exercise and assignment when deal
ing with this type of option. When acash-based option is exercised, the owner
receives cash equal to the difference between the index'sclosing price and the strike
price of the option. The option writer who is assigned must pay out an equal amount.
The following example shows how acall exercise might work. In this and the follow
ing examples we will use afictional index '.lYX (index symbols often end in X).
Example: Suppose an investor buys a '.lYX September 160 call option. At alater date,
the index has risen substantially in price and closes at 175.24 on aparticular day. The
investor decides it is time to take his profit by exercising his call option. Assuming the
'.lYX contract is worth $100 per point, just as stock options are, he receives cash in
the amount of $100 times the difference between the index closing price and the
strike price: $100 x (175.24 - 160.00) = $1,524. He has no further position or rights
- the option position disappears from his account by virtue of the exercise and he
does not acquire any security by the exercise; he gets only cash.
An assignment would work in asimilar manner, with the seller of an option hav
ing to pay out of his account cash equal to the difference between the index closing
price and the option'sstriking price. As an example, suppose that atrader sells aput
option on the '.lYX Index - the October 165 put. Subsequently, the index drops in
price, and one morning the writer of this put option finds that he has been assigned
(as of the previous day, as is the case with stock options). If the index closed at 157.58
on the previous day, then the option writer'saccount will be debited an amount equal
to $100 X (165.00 - 157.58) = $742.
EUROPEAN VERSUS AMERICAN EXERCISE
Before proceeding with more examples of index option exercise and the accompany
ing strategies, it is necessary to introduce two new definitions. American exercise
means that an option may he exercised at any time; European exercise means that an
option may only be exercised on its expiration day. Many of the cash-based index

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:541


502 Part V: Index Options and Futures
options have the European exercise feature. All stock options and some index options
have the American exercise feature.
The European exercise feature was introduced because institutional investors
who might tend to write calls against their portfolio of stocks wanted some assurance
that their protection wouldn'tbe unexpectedly taken away from them. Thus several
index option series became European exercise. Two major ones are the cash-based
index options on the S&P 500 Index (SPX) and the cash-based options on the Dow
Jones 30 Industrials. OEX remains an American exercise.
In-the-money European put options will be cheaper than their American coun
terparts. This is because an arbitrageur would have to carry the position all the way
to expiration; he could not exercise his puts and liquidate the position immediately.
In fact, deeply in-the-money European puts will trade at adiscount; the higher short
term interest rates are, the deeper the discount will be.
This can affect the full protective capability of long-term European puts. If aportfolio manager buys puts to protect his portfolio and the market crashes, the puts
might be deeply in the money. If these puts have a European exercise feature, they
would be selling at adeep discount and therefore would not have afforded all the
price protection that the portfolio manager had been looking for.
American Exercise Consideration. The primary reason for the holder of an
index option to exercise the option is to take his profit. One might think that, if the
holder wanted to take aprofit, he would merely sell his option in the open market.
Of course, if he could, he would. However, many times the deeply in-the-money
options sell at asubstantial discount during the trading day. Adeep discount is con
sidered to be 1/2 to 3/4 of apoint, or more. Near the end of the day, these options
tend to trade at only slight discounts. In either case, the holder of the option may
decide to exercise rather than to sell at any discount. Of course, if one is the holder
of acall option that is trading at asubstantial discount in the morning of aparticular
day, and he decides to exercise, he may lose more by the end of the day (if the mar
ket trades down) than he would have if he had merely sold at the deep discount in
the first place. In fact, some theoreticians feel that the "job" of adeeply in-the-money
cash-based option during the trading day is to try to predict the market'sclose. This,
of course, is not a "job" that can be consistently done with accuracy (if it could, the
traders doing the predicting would be rich beyond their wildest dreams).
If the holder of acash-based call option turned bearish, that would be another
reason to exercise. That'sright - if the holder of acash-based call option is bearish,
he should exercise because, by so doing, he liquidates his bullish position and takes
his profit. This is somewhat opposite from an option that has aphysical underlying
security, such as astock option. This presents an interesting scenario: If one turns

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:542


Chapter 29: Introduction to Index Option Products and Futures 503
bearish late in the day, even after the close, he might conceivably try to exercise his
calls to liquidate his position. The exchanges recognize that such tactics might not be
in everyone'sbest interest - for example, if one waited to see how the money supply
numbers looked on aparticular evening before exercising, he would definitely have
an advantage over the writers of those same options. The writers could no longer
viably hedge their positions after the market had closed. In order to prevent this,
cash-based option exercise notices are only acceptable until 5 minutes after the
options close trading on that exchange on any given trading day ( except expiration, of
course), in order to allow both holders and writers to be on somewhat equal footing.
There is one more fact regarding exercise of cash-based options that will inter
est brokerage customers, retail or institutional. Most brokerage firms will charge acommission for the cash-based option exercise or assignment. When index options
were first traded, commissions were quite high. Currently, however, one should gen
erally be paying acommission based upon the equivalent option price.
Example: In the previous example, one exercised a ZYX Sep 160 call at expiration
when the index closed at 175.24. This is adifferential of 15.24. One should pay acommission as if he had sold his long calls at aprice of 15.24, not on anything more.
For writers of cash-based options, things are not so different from stock options.
The writer is still warned of impending assignment by the fact that the option is trad
ing at adiscount. If it is not trading at adiscount, it is probably not in danger of being
assigned. Also, since there is no stock involved and therefore no dividends paid, the
writer of acash-based put option need only be concerned with whether the put is
trading at adiscount, not with whether it is trading at adiscount to underlying price
less the dividend, as is the case with stock options.
Traders doing spreads in cash-based options have special worries, however.
What may seem to be alimited-risk spread may acquire more risk than one initially
perceived, due to early assignment of the short options in the spread. Consider the
following example.
Example: Suppose that an investor establishes abearish call spread in ZYX options
- he buys the November 160 call at aprice of 1 and simultaneously sells the
November 155 call at 3. His risk on the spread is $300 plus commissions if he has to
pay the maximum, limited debit of $500 to buy back the spread, or so it appears.
However, suppose that the index rises substantially in price and the spreader is
assigned on the short side of his spread with the index at 175.24. He thus is charged
adebit of $2,024 to "cover" each short call via the assignment: $100 times the in-the
money amount, 175.24 - 155.00, or 20.24. He receives this assignment notice in the

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:543


504 Part V: Index Options and Futures
morning before the next trading day begins. Note that he cannot merely exercise his
long, since, if he did that, he would then receive the next night'sclosing price for his
long. Under the worst scenario, suppose the market receives disappointing econom
ic news the next day and opens sharply lower - with the index at 172. If he sells his
long Nov 160 calls at parity ($1,200), he will have paid adebit of $824 - larger than
his initial, theoretically "limited" maximum debit of $500. Thus he loses $624 on this
spread ( $824 less the initial credit of $200) - over twice the theoretically limited loss
of $300.
If the market should open sharply lower and trade down, he could lose more
money than he thought because his long position is now exposed - there is no longer
aspread in place after the short option is assigned. Of course, this could work to his
advantage if the market rallied the next day. The point is, however, that aspread in
cash-based options acquires more risk than the difference in the strikes (the maxi
mum risk in stock options) if the short option in the spread becomes adeeply in-the
money option, ripe for assignment.
NAKED MARGIN
When an index is designated as "broad-based," alesser margin requirement applies
to the writer of naked options. The SEC determines which indices are broad-based.
Abroad-based index receives more favorable margin treatment because the under
lying index will not normally change in price as quickly as astock or subindex. Thus,
the naked writer theoretically has less of arisk with anaked broad-based index
option.
The requirement for writing abroad-based index option naked is 15% of the
index, plus the option premium, minus the amount, if any, that the option is out-of
the-money. There is aminimum requirement: for calls, it is 10% of the index value;
for puts, it is 10% of the striking price. Both minima are in addition to the option pre
mium.
Example: Suppose that the ZYX is at 168.00, with a Dec 170 call selling for 6 and a
Dec 170 put selling for 5. The requirement for selling the call naked would be cal
culated as follows:
15% of index
Plus call premium
Less out-of-money amount
Naked call requirement
$2,520
+ 600
200
$2,920

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:544


Chapter 29: Introduction to Index Option Produds and Futures
The requirement for writing the Dec 170 put naked would be:
15% of index
Plus put premium
Naked put requirement
$2,520
+ 500
$3,020
Both of these requirements are above the minimum of 10% of the index.
505
Options on narrow-based indices are subject to the same naked requirements
as stock options: 20% of the index plus the premium less an out-of-the-money
amount, with aminimum requirement of 15% of the index.
Other margin requirements are similar to those for stock options. For example,
if one wanted to write the Dec 170 straddle naked, using the same prices as in the
last example, he would have amargin requirement equal to $3,020 - the larger of the
put or call requirement, just as he would for stock options. Spread requirements for
index options work in exactly the same manner as they do for stock options.
LEAPS INDEX OPTIONS
LEAPS (Long-term Equity AnticiPation Securities) have been introduced on indices
in recent years. Readers not familiar with LEAPS should review the prior chapter on
that subject. Since LEAPS have become popular for stocks, it is only logical to think
that they would become popular for indices as well.
The main problem was that a LEAPS could be a 2-year option on a 350 dollar
underlying index. Such an option might cost 20 points. That is too expensive to attract
the public customer. Just one option would cost $2,000. Therefore, the exchanges
created mini-indices out of OEX, SPX, XMI, and others. These mini-indices that
were created are exactly the same as the full indices, except that they are divided by
10. This means that instead of having the 2-year put with strike of 350 cost 20 points,
a 2-year put with astrike of 35 costs 2 points. This is much more affordable for the
individual trader.
The following example is of OEX options and the corresponding OAX LEAPS
options on the same index. NOTE: OAX is not the universal symbol for this mini
index. OEX LEAPS are American exercise, while SPX LEAPS are European. Abro
ker should be contacted for symbols, expiration dates, and other details.
Example: The following is asample comparison of prices for OEX and for its com
panion index OLX, which is OEX divided by 5. (Originally, OLX was OEX divided by
10, but when OEX split 2-for-1 in late 1997, OLX did not split so OLX was thereafter
equal to OEX divided by 5).

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:545


506
OEX: 712
Part V: Index Options and Futures
OLX: 142.40
OLX 2-year LEAPS options:
Dec 140 call: 30
Dec 150 call: 26.5
Dec 160 call: 20.5
Note that striking prices of 140, 150, and 160 for OLX correspond to 700, 750, and
800 for OEX itself. Also, if a 2-year OEX Dec 700 call existed, it would sell for
approximately five times as much as the OLX Dec 140 call, or about 150 points (5
times 30). This is why the LEAPS options use reduced-value strikes, because very
few people would have interest in trading an at-the-money option that cost 150
points ($15,000).
FUTURES
We will now take alook at how futures contracts work. This section will be concerned
only with cash-based index futures; futures for physical delivery are included in alater chapter. The ordinary stock investor might think that he will be able to employ
index option strategies without getting involved in futures. While it may be possible
to avoid futures, the strategist will realize that they are anecessary part of the entire
index-trading strategy. Thus, in order to be completely prepared to hedge one'sposi
tions and to operate in an optimum manner, the use of index futures or index futures
options is anecessary complement to nearly all index strategies.
Acomnwdities futures contract is astandardized contract calling for the deliv
ery of aspecified quantity of acertain comnwdity at some future time. The older,
more conventional types of commodities contracts were futures on grains, meats, and
metals. In recent years, futures have expanded extensively and have encompassed
financial securities - bonds, T-bills, Eurodollar Time Deposits, etc. Most recently,
futures have been issued that are cash-based; that is, no actual commodity is deliver
able. Rather, the contract settles for cash. Some of these cash-based futures contracts
have stock market indices as their underlying 'commodity. "It is this latter type of
future that will be the subject of the examples in this section, although the basic facts
regarding futures are applicable to all futures contracts, cash-based or not.
Several types of traders or investors use futures contracts. One is the specula
tor: He is able to generate tremendous leverage with futures and may be able to cap
italize on small swings in the price of the underlying commodity. Another is the true
hedger: He is adealer in the actual underlying commodity and uses futures to hedge
his price risk. This is the more economic function of futures. Examples of hedges for
physical commodities as well as stocks will be presented in later chapters. However,

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:546


Chapter 29: Introduction to Index Option Products and Futures 507
let us look at asimple example of how one might hedge astock portfolio with stock
index futures.
Example: Suppose that astock mutual fund operates under the philosophy that
investors cannot outperform abullish market, so the best investment strategy when
one is bullish is just to "buy the market." That is, this mutual fund actually buys all
the stocks in the Standard & Poor's 500 Index and holds them.
If the manager of this fund turns bearish, he would want to sell out his positions.
However, the commission costs for liquidating the entire portfolio would be large.
Also, the act of selling so much stock might actually depress the market, thereby
devaluing the remainder of his portfolio before he can sell it.
This manager might sell S&P 500 futures against his portfolio instead of selling
his stocks. Such afutures contract would move up or down in line with the S&P 500
Index as it rises or falls. Suppose that he sold enough futures to hedge the entire dol
lar value of his stock portfolio. Then, even if the stock market declined, his futures
contracts would decline also and would theoretically prevent him from having aloss.
Of course, he couldn'tmake much of again if the market went up, since the futures
would then lose money. What this money manager has accomplished is that he has
effectively sold his stock portfolio without incurring stock commission costs (futures
commissions are normally quite small).
If he turns bullish again at some later date, he can buy the futures back, and
have his long stocks free to profit if the market rises. Again, he does not spend the
stock commission nor does he have to go through the tedious process of placing 500
stock orders to "buy" the S&P 500 - he merely places one order in futures contracts.
Futures contracts often trade at premiums to the underlying commodity, due to
the fact that the investor who buys the future does not have to spend the money that
one who buys all the stocks would have to spend. Thus, he saves the carrying costs
but forsakes any dividends. This savings is reflected by the marketplace in that apre
mium is placed on the price of the futures contract. As aconsequence, longer-term
contracts trade at alarger premium than do near-term contracts, much as is the case
with options. In most cases, however, the index futures trader is concerned with the
nearest-term contract, and perhaps the next one out in time.
TERMS OF THE CONTRACT
There are cash-based index futures on several indices, although some of these futures
contracts are not heavily traded. The most heavily traded contract is the future on the
S&P 500 Index. This contract trades on the Chicago Mercantile Exchange. It has con
tracts that expire every 3 months (March, June, September, December) and a 1-point

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:547


508 Part V: Index Options and Futures
move in the futures contract is worth $250. There is no particular reason why a I-point
move is worth $250, that is merely how the contract is defined. These numbers are
subject to change. Originally, a I-point move in S&Pfutures was worth $500, but
when the S&Padvanced so much during the bull market of the 1990's, the point value
was halved in order to reduce the trading exposure in trader'saccounts. One could
surmise that afurther bull market advance might cause the number to be reduced
again, or possibly aprolonged bear market could result in an increase from $250 back
to $500, conceivably.
Example: Afutures trader buys I March S&P 500 contract at 401.00 (the smallest
unit of trading is 0.10 points, a "dime"). The contract rises in price to 403.30. The
trader has aprofit of 2.30 points, or $575 (2.30 points x $250 per point).
The terms of futures contracts can change as the exchanges on which they are
traded attempt to adjust the contracts to he more competitive in the current trading
environment. Consequently, the strategist should check with his broker to determine
the exact terms of any contract before he begins trading it.
OPEN OUTCRY
Futures contracts trade on listed commodity exchanges. However, the method of
trading is different from that used for stocks and options. Futures trade by "open
outcry" in rings or pits. Members of the exchange are the only ones allowed to trade
on the exchange, of course, just as is the case with stocks and options. If the. member
is trying to execute abuy order, for example, he would announce his bid out loud
(open outcry). Sellers would then respond by either showing him an offer or by sell
ing to him at his bid price. This differs from stocks and options which use the spe
cialist system, in that many people can be buying and selling at once, all over the pit.
It also differs from the market-maker system used on some stock options exchanges
because anyone can make the market in the commodity pit, not just adesignated few
traders.
This form of trading can produce some oddities not normally associated with
stock or stock option trading. There may be slightly different markets at different
places in alarge, busy trading pit. Hence abuyer on one side of the pit may be try
ing to pay aprice that is being offered on the other side of the pit, but the two do not
trade with each other because of the size of the trading crowd. The buyer might buy
on one side of the pit, but the seller on the other side does not sell. Then if the mar
ket trades lower, only one of the two will have received an execution even though
they were trying to buy and sell at the same price. Thus, one cannot be certain that
his futures order is executed unless the market trades through his price. That is, if

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:548


Chapter 29: Introduction to Index Option Products and Futures 509
one is bidding for futures at aprice of 1401.50 and atrade is printed at 1401.40, then
he can be certain that he has bought his contracts.
Futures exchange members who trade mainly for their own account from the
ring or pit are known as locals." They are somewhat akin to the stock option market
maker in that they may take the other side of public orders. Note, however, that they
do not have to make apublic market as market-makers do.
MARGIN, LIMITS, AND QUOTES
Futures contracts are traded on margin and are marked to market every day.
Generally, the amount of margin required is small in comparison to the total size of
the contract, so that there is tremendous leverage in trading futures. Anyone trading
the futures must deposit the initial margin amount in his account on the day he ini
tiates the trade. Then at the end of each day, the amount of gain or loss on the con
tract is computed, and the account is credited if there is again or debited if there is
aloss. In case of aloss, the trader must add more cash to his account to cover the
loss. This daily margin computation is known as maintenance margin. Treasury bills
or other securities are good collateral for the initial margin, but the daily variation
margin is required in cash.
Example: The S&P 500 futures contract is acash-based futures contract that trades
on the Chicago Mercantile Exchange. Since the contract is settled in cash, there is
no actual physical commodity underlying the contract. Rather, the contract is based
on the value of the S&P 500 stock index. At the expiration of the contract, each open
contract is marked to market at the closing price of the S&P 500 stock index and dis
appears. All contracts are settled for cash on their final day and then they no longer
exist - they expire. The terms of the contract specify that each point of movement is
worth $250. Thus, if the S&P 500 Index itself is at 1405, then the S&Pfutures con
tract is acontract on $250 x 1405, or $351,250 worth of stocks comprising the index.
Assume the initial margin for one of these contracts is $30,000, although it may vary
at specific brokerage houses.
Suppose that atrader buys one December S&Pfutures contract for his account
sometime in October. With the underlying index at 1405.00, suppose he pays 1417.50
for the futures contract. It is normal for the futures to trade at apremium to the actu
al index price. The reasons regarding this will be discussed in alater section. Initially,
the customer puts up $30,000 as margin, and this may be in the form of T-bills. On
the next day, however, the market declines and the futures close at 1406.00. This rep
resents aloss of 11.50 points from the purchase price. At $250 per point, the trader
has aloss of $2,875 (250 x 11.50) at this time. He is required to add $2,875 in cash
into the account.

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:549


510 Part V: Index Options and Futures
If he continued to hold the contract until expiration, this process of adding his
daily gain or subtracting his daily loss from the account would recur each day. Finally,
on the last day, the futures contract is deemed to close at the exact opening price of
the S&P 500 Index and the variation margin is calculated again at that price. Then
the futures contract is expired, so it is "erased" from his account. He is then left with
only the cash that he made or lost on the trade of his contract.
The leverage produced by small margin requirements (as apercent of the total
value of the contract) is amajor factor in making futures very volatile, in dollar terms.
In the preceding example, a $30,000 margin investment controls $351,250 worth of
stocks. Due to their volatility, many futures contracts trade with alimit. That is, the
price can only fluctuate afixed amount above or below the previous day'sclosing
price. This concept is intended to prevent traders with large positions from being
able to manipulate the market drastically in either direction.
S&Pand NYSE Expiration. S&P 500 futures expiration occurs in asome
what complex way, compared to those indices whose options and futures expire
at the last sale on the final day of trading. Some years ago, in order to attempt
to reduce the volatility that index futures and options expiration was causing in
the stock market, the NYSE and the Chicago Mercantile Exchange (where the
S&P 500 futures trade) agreed to change the expiration of their index products
from the end of trading on the last Friday to the morning of that day. The effect
of expiration on the stock market is discussed in the next chapter.
As aresult, the S&Pfutures and futures options as well as futures, futures
options, and index options on the New York Stock Exchange Index settle in the fol
lowing manner on their last day of trading. On expiration day - the third Friday of
the month - the "final" price for purposes of settling futures and options is comprised
of taking the opening trade of each stock and calculating an index price based on
those opening prices. There is no actual trading in the futures and options on that last
Friday; they cease trading at the close of trading on the previous day, Thursday.
The purpose of this change was to give the specialists on the New York Stock
Exchange more time to line up the other side of trades to handle order imbalances.
Under the new rules, index arbitrageurs are forced to enter their buy or sell orders
as market on open orders on that last Friday before 9 am EST. The specialist can then
take his time in opening the stock if he needs to; he can solicit orders if there is too
much stock to buy or sell.
The effect of all this is that the "final" index price for settlement purposes is not
known until all the stocks in the index have opened. It may take some time to open
all 500 stocks in the S&P 500 Index if there is avolatile market that Friday morning

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:550


Chapter 29: Introduction to Index Option Products and Futures 511
(perhaps caused by news) or if there are severe order imbalances in many of the
stocks (caused by index arbitrageurs). Index arbitrage is described in Chapter 30.
Limits. Originally, index futures traded without limits. However, the stock mar
ket crash of 1987 changed that. Certain parties felt that if the futures - which
were leading the market down - had ceased trading for awhile, the stock mar
ket could have stabilized. As aresult, aseries of trading limits now exists for
stock index futures. These are designed to be "circuit breakers" - to prevent astock market crash. They are not limits in the sense that other futures have lim
its, but they are similar.
The levels at which these circuit breakers occur may change from time to time,
based on the volatility of the stock market and the price levels at which the S&Pfutures are trading. That is, if the S&Pfutures are trading at 1500, one can expect
wider circuit breakers than if they are trading at 600. These circuit breakers only
apply to downside moves by the stock market. The first in the series of circuit break
ers usually halts trading for only 10 minutes. After that, if the market trades lower -
usually something on the order of a 10% decline - then alonger circuit breaker is
instituted for about 30 minutes or so. After that they could open again, and if they
reached the next limit down - something probably on the order of 20% then trad
ing would be halted for alonger time ( two hours or so again, the details depend on
the current regulations). If there is any time left in the trading day, they can open
again, and trade down to afinal limit, at which time trading would be halted for the
day. They could not trade any lower that day, although they could trade lower the
next day if need be.
There are similar limits imposed by the NYSE on its trading - based on the
Dow-Jones Industrial Averages. Those limits don'tnecessarily line up exactly with the
limits on the S&Pfutures. That fact might cause problems for hedgers should any of
these severe downside limits actually occur.
There are actually other "circuit breakers" designed to prevent runaway stock
markets, but they are not related to limits on futures trading. They will be described
along with index arbitrage and program trading in Chapter 30.
Quotes. While stocks and stock options are always quoted in dimes, or some
times nickels, such is not the case with futures. Some futures trade in fractions,
while others trade in cents. In the coming chapters, there will be many examples
of the trading details of futures and options. However, the investor should famil
iarize himself with the details of an individual contract before beginning to trade
it or its options. One'scommodity broker can easily supply this information.

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:551


512 Part V: Index Options and Futures
There are certain differences between the way futures trade and the way stocks
trade. One difference that is extremely important to investors accustomed to dealing
in stocks and stock options is that quotation vendors rarely show abid and offer for
futures. Thus, if one uses aquote machine to obtain the price of astock he might see
that the stock is currently 31 bid, 31.10 asked, with alast sale of 31. An active futures
contract traded on atrading floor (which is typically the type that one would want to
trade) virtually never shows abid and offer, but rather shows last sale only. In addi
tion, each sale of astock or stock option is recorded both as to its time of execution
and the quantity of execution. Such is not the case for futures. Only the price is
recorded - one cannot tell how many contracts traded at the price, nor can he tell if
there were repeated sales at that price. Where futures are traded in electronic mar
kets, of course, the bid and offer are available for all to see, and volume may accu
rately be recorded as well.
OPTIONS ON INDEX FUTURES
As we saw earlier, futures contracts allow aperson dealing in acommodity to minimize
profit fluctuations in his commodity. The mutual fund manager who sold the futures
largely removed any possibility of further upside profit or downside loss. Options,
however, allow alittle more leeway than futures do. With the option, aperson can lock
in one side of his position, but can leave room for further profits if conditions improve.
For example, the mutual fund manager might buy put options on the S&P 500 Index
to hedge his downside risk, but still leave room for upside profits if the stock market
rises. This is different from the sale of afutures contract, which locks in his profit, but
does not leave any room for further profits if the market moves favorably.
Options trade on many types of futures contracts. The security underlying the
option is the futures contract having the same expiration month, not the entity under
lying the futures contract itself. Thus, if one exercises alisted futures option, he
receives afutures contract position, not the physical commodity.
Example: Atrader owns the ZYX futures December 165 call option (165 is the strik
ing price). Assume the ZYX December future closed at 171.20. Both the calls and the
futures are worth $500 per point. If the call is exercised, the trader then owns one
ZYX December (same expiration month as the option) futures contract at aprice of
165. Since the current price is 171.20, there is amaintenance margin credit of $3,100
in his account (500 x 6.20 points). Note that even though the option is an option on
afuture which is cash-based, the exercise provides the holder of the option with afutures contract position, not with cash.

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:552


Chapter 29: Introduction to Index Option Products and Futures 513
At the present time, there are futures options on all of the various index futures
contracts.
EXPIRATION DATES
Futures options have specifics much the same as stock options do: expiration month
(agreeing with the expiration months of the underlying futures contract), striking
price, etc. If atrader buys afutures option, he must pay for it in full, just as with stock
options. Margin requirements vary for naked futures options, but are generally more
lenient than stock options. Often, the naked requirement is based on the futures
margin, which is much less than the 20% of the underlying stock price as is the case
with listed stock options.
When the futures option has acash-based futures contract underlying it, the
option and the future generally expire on the same day. Thus, if one were to exercise
a '.ZYX option on expiration day, one would receive the future in his account, which
would in tum become cash because the future is cash-settled and expiring as well.
Example: Suppose that atrader owns a '.ZYX December 165 futures worth $500 per
point - call option and holds it through the last day of trading. On that last day, the
'.ZYX Index closes at 174.00. He gives instructions to exercise the call, so the follow
ing sequence occurs:
1. Buy one '.ZYX future at 165.00 via the call exercise.
2. Mark the future at 17 4.00, the closing price. This is avariation margin profit of
$4,500 (174.00-165.00) X $500.
3. The option is removed from the account because it was exercised, and the future
is removed as well because it expired.
Thus, the exercise of the option generates $4,500 in cash into the account and leaves
behind no futures or option contracts. We do not know if this represents aprofit or
loss for this call holder, since we do not know if his original cost was greater than
$4,500 or not.
It should be noted that futures option expiration dates, in general, are fairly
complex. They are not normally the third Friday of the expiration month, as stock
options are. Index futures options generally do expire on the third Friday of the expi
ration month, but many physical commodity options do not. These differences will
be discussed in the later chapter on futures options.

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:553


514 Part V: Index Options and Futures
OPTION PREMIUMS
The dollar amount of trading of afutures option contract is normally the same as that
of the underlying future. That is, since the S&P 500 future is worth $250 per point,
so are the S&P 500 futures options. The same holds true for the New York Stock
Exchange Index options.
Example: An investor buys an S&P 500 December 1410 call for 4.20 with the index
at 1409.50. The cost of the call is $1,050 (4.20 x 250). The call must be paid for in
full, as with equity options.
An interesting fact about futures options is that the longer-term options have a
"double premium" effect. The option itself has time value premium and its underly
ing security, the future, also has apremium over the physical commodity. This phe
nomenon can produce some rather startling prices when looking at calendar spreads.
Example: The ZYX Index is trading at 162.00 sometime during the month of
January. Suppose that the March ZYX futures contract is trading at 163.50 and the
June futures contract at 167.50. These prices are reasonable in that they represent apremium over the index itself which is 162.00. These premiums are related to the
amount of time remaining until the expiration of the futures contract.
Now, however, let us look at two options - the March 165 put and the June 165
put. The March 165 put might be trading at 3 with its underlying security, the March
futures contract, trading at 163.50. The June 165 put option has as its underlying
security the June futures contract. Since the June option has more time remaining
until expiration, it will have more time value premium than a March option would.
However, the underlying June future is trading at 167.50, so the June 165 put option
is 2½ points out-of-the-money and therefore might be selling for 2½. This makes avery strange-looking calendar spread with the longer-term option selling at 2½ and
the near-term option selling for 3. This is due to the fact, of course, that the two
options have different underlying securities. One is in-the-money and the other is
out-of-the-money. These two underlyings - the March and June futures - have aprice differential of their own. So the option calendar spread is inverted due to this
double premium effect.
FUTURES OPTION MARGIN
Most futures exchanges have gone to the form of option margin called SPAN, which
stands for Standard Portfolio Analysis of Risk. This form of margining is very fair and
attempts to base the margin requirement of an option position on the probability of

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:554


Chapter 29: Introduction to Index Option Products and Futures 515
movement by the underlying futures contract, as well as on the potential change of
implied volatility of the options in question.
The older method of margining option positions is known as the "customer mar~
gin" method. The customer margin method generally results in higher margin
requirements. The reader is referred to the chapter on futures and futures options
for an in-depth discussion of SPAN and other option margin requirements.
OTHER TERMS
Just as futures on differing physical commodities have differing terms, so do options
on those futures. Some options have striking prices 5 points apart while others have
strikes only 1 point apart, reflecting the volatility of the commodity. Specifically, for
index futures options, the S&P 500 options have striking prices 5 points apart, and
the NYSE options have striking prices 2 points apart.
There is no standard method for quoting futures on options as there is with
stock options. In some cases, striking price symbols are similar to stock option sym
bols (A=5, B=lO, C=l5, etc.), while in others the letters are used incrementally (A=l,
B=2, C=3, etc.). Moreover, the method used may differ with each quote vendor. In
some cases, quote systems use the numeric value of the strike instead of letters. This
makes quoting options much simpler, and perhaps the entire industry (including
stock option vendors) will adopt this method someday. Since there is no standard
method for quoting, one must obtain the symbols individually for futures options, afact that makes quoting them extremely inconvenient.
There are position limits for some futures options, hut they allow for very large
positions. Check with your broker for exact limits in the various futures options.
QUOTES
Most futures option quotes (bids and offers) are not displayed on quote-vending
machines, as is also the case with futures. Options traded on the Chicago Mercantile
Exchange are the exception. This can he somewhat distressing to the trader used to
dealing in stock options, since options are normally far less liquid than the underly
ing security. It might be acceptable to trade off of last sales in aliquid futures con
tract, but not so with the options. As aresult, futures options have not attracted many
stock option traders into their fold. Of course, where electronic markets exist, the
bids and offers of options would be shown publicly.
The consequence of the inconsistencies in terms as well as the general unavail
ability of quotes has been that index futures options are generally traded by profes
sionals, with the public largely ignoring them. This does not mean, however, that

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:555


516 Part V: Index Options and Futures
futures options are unworthy of the strategist'stime and effort. In fact, just the oppo
site may be true - the lack of general information may produce some inefficiencies
that the strategist can benefit from.
One factor concerning the trading of futures options can be of major concern
to many customers and salesmen. Salesmen who are registered to sell stocks are not
necessarily registered to sell futures - an additional test must be passed in order to
sell many types of futures options. Similarly, many customers - primarily institutions
- have received approval from their constituents to trade in stock options, but would
need further approvals to trade futures or futures options. Neither of these things
should stand in the way of the strategist - if there are opportunities in futures
options, then the customer should find abroker who can trade them. Also if the
strategist finds that he requires certain approvals from within his own institution
before he can trade futures, then he should obtain those approvals.
STANDARD OPTIONS STRATEGIES USING INDEX OPTIONS
The stock option strategies described in all of the preceding chapters of this book can
be established with index options as well. The concepts are normally the same for
index options as they would be for stock options. If one buys acall at one strike and
sells acall at ahigher strike, that is abullish spread; if one sells both aput and acall
at the same strike (astraddle), that is aneutral strategy. One uses deltas to determine
how many options to sell against the ones that he buys in order to establish adelta
neutral strategy. Likewise, he uses the deltas to tell, along the way, how his position
is progressing and how to adjust it to keep it delta neutral.
We will not describe these same strategies over again. They have already been
described in detail. The risk of early assignment removing one side of aposition can
alter some strategies. In some cases there are particular advantages or disadvantages
with index options and futures. Thus, we will briefly go over some major option
strategies, giving details pertaining to their usage as index option strategies.
OPTION BUYING
The most common reason for wanting to buy index options is to take advantage of the
diversification that they provide, in addition to the normal advantages that option
purchasing provides: leverage and limited dollar risk. Many people feel that it is eas
ier to predict the general market direction than it is to predict an individual stock'sdirection. This feeling, can, of course, be put to good advantage by buying index
options. However, sometimes it is not better to buy the index options. In such cases,
it may actually be smarter to purchase apackage of individual stock options.

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:556


Chapter 29: Introduction to Index Option Products and Futures 517
Due to aphenomenon known as volatility skewing, it is possible for index
options to have implied volatilities that are out of line with projected index or stock
price movements. This phenomenon is discussed in detail in the chapter on advanced
concepts.
For example, suppose that index puts are expensive, as they became after the
1987 stock market crash. When this happens it may actually be more profitable for atrader who is bearish on the market to buy apackage of equity puts instead of buy
ing index puts. The equity puts are forced to reflect the probability of stock price
movement because arbitrage strategies will keep them in line. They will therefore be
less expensive than index puts when this type of volatility skewing is present. Index
puts can remain expensive for several reasons - primarily excessive demand and
inflated margin requirements. In such situations, it is theoretically correct to buy agroup of puts on stock options. In fact, one might even hedge this purchase by sell
ing out-of-the money, overpriced index puts.
SELLING INDEX OPTIONS
In earlier chapters, we saw that many mathematically attractive strategies involve the
sale of naked options - ratio writes, straddles, ratio spreads, etc. Index options pres
ent an even stronger case for these strategies. Recall that the greatest risk in these
strategies with naked options is that the underlying security might move agreat dis
tance, thereby exposing the position to great loss if the movement is in the direction
in which the naked options lie. That is, if one is naked calls and the underlying secu
rity rises dramatically, perhaps on atakeover bid, then large losses - potentially
unlimited in the absence of follow-up action - could occur.
The strategist would, of course, never let the loss run uncontrolled. He would
attempt to take some follow-up action to limit the loss or to neutralize the position.
However, even the best strategist cannot hedge his position if the movement in the
underlying occurs while the market is closed. For example, if the underlying securi
ty is astock, certain news items might cause alarge gap to occur between the closing
price of astock and its next opening price. Such news might be related to atakeover
of the company or to adrastically negative earnings report, for example.
Index options do not have this particular drawback. An index - especially abroad-based index - is not as likely to open on awide gap as astock is. An index can
not be the subject of atakeover attempt. It cannot be severely depressed by bad earn
ings on one of its components. Thus, index options are more viable candidates for
strategies involving naked option writing than stock options are. Index futures and
options may often open on small gaps of apoint or so, due to emotion or possibly due
to the fact that amarket that opens earlier (T-Bond futures, for example) has already

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:557


518 Part V: Index Options and Futures
made arather large move by the time the futures open. Such asmall gap is normal
ly not extremely damaging to the naked writer.
One cannot assume that an index can never gap open widely - if something
drastic were to happen in the marketplace that caused opening gaps in many stocks,
then agap could appear in the index itself. The worst case of such agap, percentage
wise, was the stock market crash in 1987 when the major indices such as OEX and
S&P 500 opened down over 20 points. Nothing has come close to that before or
since, but the possibility always exists that it could happen again. Therefore, one can
not assume that naked option writing of index options is alow-risk strategy; howev
er, it is generally less risky than naked option writing of equity options.
HANDLING EARLY ASSIGNMENT OF CASH-BASED OPTIONS
The greatest problem that aspreader of index options has is the possibility of early
assignment. This removes his hedge on one side of his position, exposing him to
much more risk than he had wanted or anticipated.
One can often obtain aclue before early assignment occurs by observing the
price of the in-the-money options. If they are trading at adiscount, one can expect
assignment to be more likely.
Example: '.lYX is trading at 357 afew days before expiration of the January options.
The stock market rallies heavily near the close, and the January 340 calls are trading
with amarket of 16½ to 16¾ after 4 pm EST. Since parity is 17 for these calls, it is
likely that awriter will receive an assignment notice in the morning.
The strategist who observes this situation taking place must make arather quick
decision. Since the market has rallied heavily on the close, it is likely that arbitrageurs
or institutional accounts who are long index options are going to exercise them. The
cynic among us would even think that they might be short stocks as well which they
plan to cover in the morning. Notice that the effect of hedged call option sellers (i.e.,
spreaders) receiving assignment notices will be to make them all long the market.
The short side of their spread will have been removed via assignment, and they will
be left with only the long side. Therefore, in order to liquidate or hedge, they will
have to sell stocks or index futures and options in the morning. This would force the
market down temporarily and would be aboon to anyone who was short overnight.
The spreader'sfirst potential choice of action is to notice what is happening near
the close of trading and to try to exercise his long calls since he expects assignment
of his short calls. The assignment, of course, is not certain - he is merely projecting
it. Therefore, he could outfox himself and end up being very short if he did not
r~ceive an assignment notice on his short calls.

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:558


Chapter 29: Introduction to Index Option Products and Futures 519
Assuming the strategist did not anticipate assignment and therefore did not
exercise his long calls, he has several choices after receiving an assignment notice the
next morning. First, he could do nothing. This would be an overly aggressive bullish
stance for someone who was previously in ahedged position, but it is sometimes
done. The strategist who takes this aggressive tack is banking on the fact that the sell
ing after the assignment will be temporary, and the market will rebound thereafter,
giving him the opportunity to close out his remaining longs at favorable prices. This
is an overly aggressive strategy and is not recommended.
The most prudent approach to take when one receives an early assignment on
acash-based option is to immediately try to do something to hedge the remaining
position. The simplest thing to do is to buy or sell futures, depending on whether the
assignment was on aput or call. If one was assigned on aput, aportion of the bull
ishness (short puts are bullish) of one'sposition has been removed. Therefore, one
might buy futures to quickly add some bullishness to the remaining position.
Generally, if one were assigned early on calls, part of the bearishness of his position
would have been removed - short calls being bearish - and he might therefore sell
futures to add bearishness to his remaining position. Once hedged, the position can
be removed during that trading day, if desired; by trading out of the hedge estab
lished that morning.
One should receive this assignment notice early in the morning, so he can
immediately hedge his position in the overnight markets. If he waits until the day ses
sion opens, he might use futures or options to hedge. One should be particularly
careful about placing market orders in an opening option rotation, especially on index
options after asevere downside move has occurred the previous day. Market makers
are very nervous and are not willing to sell puts as protection to the public in that sit
uation. Consequently, puts are notoriously overpriced after alarge down day in the
stock market. One should refrain from buying put options in the opening rotation in
such acase. In the future, it is possible that comparable situations may exist on the
upside. To date, however, all gaps and severe mispricing anomalies have been on the
bearish side of the market, the downside.
CONCLUSION
The introduction of index products has opened some new areas for option strategists.
The ideas presented in this chapter form afoundation for exploring this new realm
of option strategies. Many traders are reluctant to trade futures options because
futures seem too foreign. Such should not be the case. By trading in futures options,
one can avail himself of the same strategies available in stock option. Moreover, he
may be able to take advantage of certain features of futures and futures options that

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:559


520 Part V: Index Options and Futures
are not available with stock options. For example, if one were to try to use options to
construct astrategy based on his expectation of interest rate movements, he could
use T-Bond futures and options, which is the easiest way. However, if he were to try
to remain with stock options, he would probably be forced to do something with util
ity stocks or illiquid interest rate options - aclearly inferior alternative.
Trading in index options can be very profitable, but only if one understands the
risks involved - especially the risk of early assignment in cash-based options. The
advantages to being able to "trade the market" as opposed to trading one stock at atime are obvious: If one is right on the market, his index option strategies will be
profitable. This is superior to stock-oriented buying whereby one might be right on
the market, but not make any money because calls were bought on stocks that didn'tfollow the market.
The strategist should consider all of his alternatives when trading in these mar
kets. If he is bullish, should he really be buying OEX calls? Maybe futures calls on
the S&P 500 are better. Perhaps the OEX is expensive with respect to the NYSE and
the NYA calls would be abetter buy. In fact, perhaps all the calls are so expensive
that stock options are the best buy. The ideas presented in this chapter lay the
groundwork for the strategist to explore these questions and make the best decision
for his investment strategy.
Finally, keep in mind that the index futures and options comprise avery diverse
set of securities. They can be put to work for the investor, the trader, and the strate
gist in amultitude of ways. The only practical limit is in the mind of the user of these
derivative securities.
PUT-CALL RATIO
Generally, we have not been concerned with technical trading systems in this book.
Not that they aren'timportant, they are just in another category of investments other
than option strategies. However, the put-call ratio system is so closely related to
options that its inclusion is worthwhile.
The put-call ratio is simply the number of puts traded divided by the number
of calls traded. It can be computed daily, weekly, or over any other time period. It
can be computed for stock options, index options, or futures options. Sometimes it
is computed using open interest instead of volume. Another way to compute the put
call ratio is to divide the dollars spent on puts (sum of each put price times its trad
ing volume) divided by the dollars spent on calls (sum of each call price times its
trading volume). If it is calculated daily, one usually averages several days' worth of
figures to smooth out the fluctuations.

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:560


Chapter 29: Introduction to Index Option Products and Futures 521
Example: The morning paper shows that yesterday the trading activity for OEX
options was:
Total OEX Call Volume: 125,000 Contracts
Total OEX Put Volume: 135,000 Contracts
Therefore, the ratio is:
. 135 000 Index Put-Call Ratio= ' = 1.08 for yesterday
125,000
This technical indicator is acontrary one. The contrarian thinking is along these lines:
if everyone is buying puts, then everyone must be bearish; if everyone is doing some
thing, they can'tall be right; therefore the contrarian must assume abullish stance.
So, if the put-call ratio is high, too many traders are buying puts; acontrarian
would interpret that as abullish sign. Conversely, if the put-call ratio is low, too many
traders are buying calls; the contrarian would consider that as abearish indicator. The
theory behind contrary systems is that the majority of traders are wrong at major
turning points in the market.
There are several typical put-call ratios that can be computed. Generally, one
would not want to mix different types of options. For example, the equity put-call
ratio uses the option trading volume of equity options only. The index put-call ratio
uses index options only. Each futures contract put-call ratio is generally computed
separately, gold, soybeans, currencies, etc. One might also attempt to screen his input
alittle further: for example, the index put-call ratio should only include index options
on U.S. exchanges; the others can be computed separately.
Obviously, the more highly traded option contracts produce amore reliable put
call ratio: equity options and index options being very liquid. Gold futures options by
themselves are not that active and may produce distorted results for aperiod of time.
The Ratio Itself. Traders and investors almost always buy more calls than
puts where stock options are concerned. Therefore, the equity put-call ratio is
normally anumber far less than 1.00. If call buying is rampant, the equity put
call ratio may dip into the 0.30 range on adaily basis. Very bearish days may
occasionally produce numbers of 1.00 or higher. An average day will generally
produce aratio of around 0.50.
Index options, however, produce much larger ratios. Many institutional and
other investors are constantly looking to avail themselves of the protective capability
of index puts. Therefore, far more index puts are purchased than are equity puts. An
average day might produce readings of 2.00 for some indices.

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:561