Over the following four chapters, you’ll work with different types of non-equity options. Instead of using a stock as the underlying security, these options are based on the market value movements of something else.
We’ll learn about these four non-equity options:
Non-equity option investors use options for the same core reasons equity option investors do:
The strategies are generally the same. For example, a long S&P 500 call is bullish on the S&P 500 index. The key difference is simply the underlying asset tied to the option.
We’ll start with index options.
We briefly covered index options earlier in this unit. Index options derive their value from changes in a specific index’s value. For example, you could trade an S&P 500 index option contract that pays off if the index falls, stays flat, or rises (depending on whether you buy a put or a call, and where the index finishes relative to the strike).
Instead of betting on a single stock’s price, index option investors are betting on index value fluctuations. Many indices have listed options, but these are the ones most likely to appear on the exam:
SPX - S&P 500
OEX - S&P 100
DJX - Dow Jones Industrial Average
RUT - Russell 2000
VIX - Volatility index
Indices give a “high-level” view of the market. You’ve probably seen the news report the Dow Jones and the S&P 500 as quick gauges of U.S. market conditions.
Different indices emphasize different parts of the market. For example, if the Russell 2000 is down but the S&P 100 is up, that suggests small-cap stocks are having a weaker day while large-cap stocks are holding up better.
Throughout this chapter, you’ll see that index options behave a lot like equity options. However, there are two important differences to keep in mind.
First, you learned in a previous chapter that most index options are European style, meaning they can only be exercised at expiration. This is true for virtually all index options, with one major exception: the OEX (S&P 100). The reason isn’t important here, but the OEX is one of the only American style index options, meaning it can be exercised at any time.
As a reminder, all equity (stock) options are American style.
The second difference is what happens at exercise. When an index option is exercised, no shares are bought or sold. If an S&P 500 option worked like an equity option, exercise would imply trading stock across 500 companies. Instead, index option exercises settle in cash.
We’ll build on this idea later.
When an equity option is exercised, settlement occurs over one business day (T+1). With an index option, there are no shares to deliver, but index options still use T+1 settlement.
Let’s jump into some math-based index option questions. Assume this position:
Long 1 SPX 4500 call at $20
Using your fundamental options knowledge, find the following:
- Maximum gain
- Maximum loss
- Breakeven
- Gain or loss at 4,550
- Gain or loss at 4,450
Just like an equity option, a long call has unlimited gain potential. The investor has the right to buy at 4,500. The further the S&P 500 index rises above 4,500, the more the investor gains.
If the S&P 500 index finishes below 4,500, the option is out of the money and expires worthless. The worst-case outcome for a long option is losing the premium paid.
A $20 premium equals $2,000 ($20 x 100 multiple).
At 4,520, the call is in the money by $20. If exercised, the writer must pay the intrinsic value in cash.
That $2,000 cash settlement offsets the $2,000 premium paid, so the net result is breakeven.
At 4,550, the call is in the money by $50.
Net profit = $5,000 − $2,000 = $3,000.
At 4,450, the call is out of the money and expires worthless. The holder loses the premium paid: $2,000 ($20 x 100).
As you can see, index options are very similar to equity options. You can use the same formulas from the long call chapter to answer questions like this.
Let’s try another example:
Short 1 RUT 2000 put @ $15
Using your fundamental options knowledge, find the following:
- Maximum gain
- Maximum loss
- Breakeven
- Gain or loss at 2,040
- Gain or loss at 1,960
The maximum gain on any short option is the premium received. A short put is bullish: the investor wants the RUT to stay at or above 2,000. If it does, the put expires worthless and the investor keeps the $1,500 premium ($15 x 100).
A short put loses more as the market falls. If the RUT drops below 2,000, the put becomes in the money and gains intrinsic value.
Theoretically, the index could fall to zero (unlikely, but it defines the maximum loss). Maximum loss is calculated as:
Strike − premium = 2,000 − 15 = 1,985
Loss at zero = $1,985 x 100 = $198,500
Breakeven = 1,985 (strike - premium)
At 1,985, the put is in the money by $15.
That $1,500 loss at exercise offsets the $1,500 premium received, so the net result is breakeven.
At 2,040, the put is out of the money and expires worthless. The investor keeps the premium: $1,500.
At 1,960, the put is in the money by $40.
Net loss = $4,000 − $1,500 = $2,500.
Again, the fundamentals of options still apply. You can use the same formulas from the short put chapter to answer questions like this.
Investors commonly use index options to hedge against market risk, a type of systematic risk.
If you had money invested during the initial outbreak of COVID-19 (Coronavirus), you saw market risk in action. In March 2020 alone, the S&P 500 lost over 12%. A 12% decline over a full year is painful; a decline of that size in one month can be devastating.
There are exceptions, but most investors experience losses during broad market declines. Even well-diversified portfolios across sectors and geographic regions can still fall when the overall market falls. This is why investors cannot diversify out of market risk.
While you can’t diversify away market risk, you can hedge it. As covered in the hedging strategies chapter, an investor can hedge by buying an option that tends to profit when the market moves against the portfolio.
For a large diversified stock portfolio, buying (going long) index puts can help offset losses during a broad market decline. If an unexpected recession hits, gains on the long index puts may help reduce the portfolio’s overall loss.
You may see a question like this on the exam:
An investor owns a diversified portfolio of stocks currently worth $600,000. They want to fully hedge against market risk. Which of the following would best protect the portfolio?
A) Short 5 OEX 2000 puts
B) Long 5 OEX 2000 puts
C) Short 3 OEX 2000 puts
D) Long 3 OEX 2000 puts
First, eliminate the choices that don’t fit a hedge.
That eliminates A and C.
Next, find how much portfolio value each index option hedges:
So each OEX 2000 put hedges $200,000 of portfolio value.
Last, divide the portfolio value by the hedge per contract:
So the best answer is D.
Let’s see if you can work through one on your own:
An investor owns a well-diversified portfolio of large-cap stocks currently worth $1,400,000. They want to fully hedge against systematic risk. To adequately protect their portfolio, which investment should you recommend?
A) Long 40 DJX 350 calls
B) Long 40 DJX 350 puts
C) Long 20 DJX 350 calls
D) Long 20 DJX 350 puts
Answer = B) Long 40 DJX 350 puts
First, choose the option that profits in a market decline. Long calls are bullish and won’t help if the market falls, so eliminate A and C.
Next, find how much each DJX 350 put hedges:
Last, divide the portfolio value by the hedge per contract:
So the investor should buy 40 DJX 350 puts.
There’s one more layer to portfolio protection: a portfolio’s beta.
A portfolio with a beta of 1.0 has historically moved about the same as the market.
A portfolio with a beta above 1.0 is more volatile than the market.
A portfolio with a beta between 0.0 and 1.0 is less volatile than the market.
A portfolio with a negative beta tends to move opposite the market.
Here’s a table summarizing what we just discussed:
| S&P 500 return | Portfolio beta | Portfolio return |
|---|---|---|
| Up 10% | 1.0 | Up 10% |
| Up 10% | 1.5 | Up 15% |
| Up 10% | 0.5 | Up 5% |
| Up 10% | -2.0 | Down 20% |
Beta can also show up in a hedging question. For example:
An investor owns a well-diversified portfolio of small-cap stocks with a beta of 1.4, currently worth $1,000,000. They want to fully hedge against systematic risk. To properly protect their portfolio, which investment should you recommend?
A) Long 7 RUT 2000 puts
B) Short 7 RUT 2000 calls
C) Short 5 RUT 2000 calls
D) Long 5 RUT 2000 puts
Because the portfolio has a beta of 1.4, it’s expected to move 1.4 times as much as the market (in this case, relative to the index being used). That means it needs more protection than a beta 1.0 portfolio.
The clean way to solve these is to follow the same steps each time.
Step 1: eliminate wrong answers
Although short calls are bearish, their maximum gain is limited to the premium. If the market declines sharply, the investor’s protection is capped.
For hedging, investors typically buy (go long) options.
Eliminate answers B and C.
Step 2: Find the amount of protection each option gives
Each RUT 2000 put covers $200,000 of portfolio value.
Step 3: Divide portfolio value by option coverage
A $1,000,000 portfolio with beta 1.0 would need 5 contracts. At this point, D might look correct - but beta still needs to be applied.
Step 4: Multiply the contracts initially required by beta
So the investor needs 7 long RUT 2000 puts, which is answer choice A.
Let’s see if you can do one on your own:
An investor owns a well-diversified portfolio of large-cap stocks with a beta of 2.5, currently worth $800,000. They ask for your help in properly hedging against market risk. Which of the following should you recommend?
A) Long 4 SPX 2000 puts
B) Short 4 SPX 2000 puts
C) Long 10 SPX 2000 puts
D) Short 10 SPX 2000 puts
Answer = C) Long 10 SPX 2000 puts
First, eliminate the short puts. Short puts are bullish and won’t help if the market falls. Also, hedging is typically done by buying options, not selling them. Eliminate B and D.
Second, find how much each put option covers:
Third, divide the portfolio value by the coverage per contract:
A beta 1.0 portfolio would need 4 long SPX 2000 puts.
Last, adjust for beta:
So the correct recommendation is 10 long SPX 2000 puts.
When the market falls, portfolios with betas above 1.0 tend to fall faster and further than the market. That’s why higher-beta portfolios require more contracts to hedge the same dollar value.
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