Russell Rhoads is an instructor with The Options Institute at the Chicago Board Options Exchange. He is a financial author and editor having contributed to multiple magazines and edited several books for Wiley publishing. In 2008 he wrote Candlestick Charting For Dummies and is the author of Option Spread Trading: A Comprehensive Guide to Strategies and Tactics. Russell also wrote Trading VIX Derivatives: Trading and Hedging Strategies using VIX Futures, Options and Exchange-Traded Notes. In addition to his duties for the CBOE, he instructs a graduate level options course at the University of Illinois - Chicago and acts as an instructor for the Options Industry Council. Russell:
Two weeks ago I discussed S&P 100 (OEX) index options as a good candidate for a first index option trade. In the comments for that article there was a request to show a trade using S&P 100 Index OEX options. Based on that comment I'm going to look at a basic bullish idea using weekly options that trade on the OEX. This example is also a method I use in my own trading when I have an opinion about the direction of the overall market. You can also think of this as a strategy to consider if you believe you have an opinion on the direction of the stock market for the next few days.
Since hindsight is 20/20 let's take a look at a bullish trade on the OEX from a couple of weeks ago. Below is a chart of the OEX From the beginning of 2012 through Thursday March 8. The OEX was around 618 after the market settled down after the open on March 8. The option prices used in this example come from just after the open on that day as well. March 8 is a Thursday and every Thursday there is always an OEX option series expiring the following Friday, either in the form of standard options or Weeklys. Barring a holiday this represents option contracts that have seven trading days remaining until expiration. Extending the trend line forward by seven days would put support for the OEX at around 615, seven trading days into the future. Using this very basic outlook as the basis for a trade we could take a look at selling an OEX Put with a 615 strike price that expires on Saturday March 17 (trading through the close on March 16). This OEX March 615 put could be sold at $3.60. A short put is not appropriate for all traders. Often special brokerage approval is necessary to initiate a naked short option position. Combined with this short 615 put we could consider buying a 610 put at $2.50 or the 605 put for $1.60. Your decision would be based on your risk tolerance and how certain you are on the outcome of the trade. Selling the 615 put and buying either of the other contracts would result in a bull put spread.
For those of us that do not watch the market full time (that is we have a job to attend to) bull and bear spreads are one of my favorite suggestions for option trades. Your maximum risk is known along with maximum reward with one of these spreads. Also, you can actually profit if you are slightly wrong (this example is one of those cases). Finally, if constructed properly, you can get time decay working for you. Although these are all excellent reasons to trade bull or bear spreads, the ability to exit a position early always exists as well.
In this case we will buy an OEX March 605 put for $1.60 and sell an OEX March 615 put at $3.60. The net result is a credit of $2.00. Most option traders are aware the result here is a maximum profit of $2.00 as long as the OEX is over 615.00 at expiration. The maximum losses for this trade occurs if the OEX is at 605.00, or lower (a drop of just over 2%) at option expiration. Finally, a payout diagram for this trade if held to expiration appears below. Note on the payoff diagram that 618.00 (the price level for the OEX when the trade could have been initiated) is well within the maximum profit range at expiration.