Over the next four chapters, you’ll work with different types of non-equity options. In these contracts, the underlying security isn’t a stock. Instead, the option’s value is tied to the market value of something else.
We’ll cover 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 the option is based on.
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 the strike price and whether you use calls or puts).
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 on the Dow Jones and the S&P 500 as quick gauges of U.S. market conditions.
Different indices highlight 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.
Index options behave a lot like equity options, but there are two important differences to keep in mind.
First, as you learned in a previous chapter, most index options are European style, meaning they can only be exercised at expiration. There’s 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 500 different stocks, which isn’t practical. Because of the size and structure of indices, index option exercises settle in cash.
When a holder exercises an index option, the writer must deliver the option’s “in the money” amount (intrinsic value) in cash. We’ll build on this idea later.
When an equity option is exercised, settlement occurs over one business day (T+1). Index options also settle T+1.
Let’s work through 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 profits.
If the S&P 500 index is below 4,500 at expiration, the option is out of the money and expires worthless. The worst-case outcome for the holder is losing the premium. A $20 premium equals $2,000 ($20 x 100 multiple).
At 4,520, the option is in the money by $20. On exercise, the writer must deliver the intrinsic value in cash. Here, $20 in the money means the writer delivers $2,000 ($20 x 100 multiple), which offsets the $2,000 premium paid.
At 4,550, the option is in the money by $50. The writer must deliver $5,000 ($50 x 100 multiple). After subtracting the $2,000 premium paid, the net profit is $3,000.
At 4,450, the option is out of the money and expires worthless. The holder loses the $2,000 premium ($20 x 100 multiple), which is the maximum loss.
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 these.
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, so the investor wants the RUT to stay above 2,000. If it does, the option expires worthless and the investor keeps the $1,500 ($15 x 100) premium.
A short put loses more as the market falls. If the RUT drops below 2,000, the option goes in the money and gains intrinsic value.
Theoretically, the index could fall to zero (though this would require all 2,000 companies in the Russell 2000 to go out of business).
Maximum loss is calculated as strike minus premium: 2,000 - 15 = 1,985. If the index were at zero, the option would be in the money by $1,985, producing a loss of $198,500 ($1,985 x 100).
At 1,985, the option is in the money by $15. If exercised, the writer must deliver $1,500 ($15 x 100) in cash. That $1,500 loss offsets the $1,500 premium received.
At 2,040, the option is out of the money and expires worthless. The investor keeps the $1,500 premium.
At 1,960, the option is in the money by $40. On exercise, the writer delivers $4,000 ($40 x 100). After subtracting the $1,500 premium received, the net loss is $2,500.
The same option fundamentals apply here as well. You can use the formulas from the short put chapter to answer questions like this.
Investors commonly use index options to hedge against market risk, which is 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 year is difficult; a 12% decline in a single month can be devastating.
There are exceptions, but most investors experience losses during very 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.
Even though you can’t diversify away market risk, you can hedge it. As discussed in the hedging strategies chapter, an investor can protect a portfolio by going long an option that profits during an adverse market move.
For example, an investor with a large diversified portfolio could buy (go long) index puts. If an unexpected recession occurs, gains on the long index puts could help offset losses elsewhere in the portfolio.
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
Start by eliminating choices that don’t fit a hedge. A hedge is typically created by buying (going long) an option. Selling options leaves the investor exposed to assignment risk, and a short put is bullish, so it won’t offset losses in a market decline. Eliminate A and C.
Next, determine how much portfolio value each index option hedges:
Finally, divide the portfolio value by the coverage per contract:
The investor should buy three OEX 2000 puts, so the answer is D.
Try 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:
Then divide the portfolio value by the coverage 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 in line with the market. If the S&P 500 was up 10% last year, this portfolio would be expected to be up about 10% (10% x 1.0).
A portfolio with a beta above 1.0 is more volatile than the market. For example, a beta of 1.5 suggests the portfolio tends to move 1.5 times as much as the market. If the S&P 500 was up 10%, the portfolio would be expected to be up 15% (10% x 1.5).
A portfolio with a beta between 0.0 and 1.0 is less volatile than the market. For example, a beta of 0.5 suggests the portfolio tends to move about half as much as the market. If the S&P 500 was up 10%, the portfolio would be expected to be up 5% (10% x 0.5).
A portfolio with a negative beta tends to move opposite the market. For example, a beta of -2.0 suggests the portfolio tends to move about twice as much as the market, but in the opposite direction. If the S&P 500 was up 10%, the portfolio would be expected to be down 20% (10% x -2.0).
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 appear 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
This portfolio moves 1.4 times faster than the market and needs extra protection in a market decline. You can approach the question in the same sequence as before.
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 at that premium. For hedging, investors should buy (go long) options to gain protection (hedge). Eliminate B and C.
Step 2: Find the amount of protection each option gives
Multiply the strike price (2,000) by 100 (option multiple):
So each RUT 2000 put covers $200,000 of portfolio value.
Step 3: Divide portfolio value by option coverage
So a $1,000,000 portfolio with volatility similar to the RUT would require 5 long RUT 2000 puts.
If you stop here, you’d pick D - but there’s one more step.
Step 4: Multiply the contracts initially required by beta
Because the portfolio has a beta of 1.4, it’s expected to move 1.4 times as much as the index. Multiply the initial contract count by beta:
So the correct answer is A: 7 long RUT 2000 puts.
Try 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 covers:
Third, divide the portfolio value by the coverage per contract:
So a portfolio with market-like volatility would need 4 long SPX 2000 puts.
Finally, adjust for beta. This portfolio is 2.5 times as volatile as the market:
So the correct recommendation is 10 long SPX 2000 puts.
When the market falls, portfolios with betas above 1.0 will typically fall faster and further than the market. That’s why higher-beta portfolios require more option contracts to hedge the same dollar value.
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