E-MINI OPTIONS: BUYING CALLS
Let's say that you have just watched the E-mini® S&P 500® recover strongly from a significant dip in price and
this has convinced you that the market will be heading higher. (See chart at right.) Based on your study
of cycles, you expect that the market will rally for about a month before hitting resistance and you're
interested in buying an E-mini S&P 500 call option to profit should this happen.
The first step of the
purchase decision
is to determine the maturity of the call option: it must be long enough to capture the anticipated price rally.
The December 2009 E-mini S&P 500 call options expire in
five weeks and
you feel that's sufficient. The second step is determining the strike price.
December E-mini S&P 500 call options are available across a wide range of strike prices, each having a different cost.
(See table at right.)
Reading E-mini S&P 500 Option Prices
E-mini S&P 500 options are priced in index points up to two decimals. One E-mini S&P 500 option can be exercised into one
E-mini S&P 500 futures contract and since each contract has a multiplier of $50, the option price must also be
multiplied by $50 to get a corresponding dollar value and every one point change in the price of the option or the underlying
futures for that matter is worth $50 per contract.
For example, the December E-mini S&P 500 call option struck at 1090 settled at 30.00 index points. The dollar value
of this option is $50 x 30.00 = $1,500. This call option is at-the-money
since the December futures contract settled the day at 1,091.75 index points. Notice that the futures closed
higher over the day by 25.50 index points taking all call option prices higher as well but that the option prices moved by less
than this amount. In fact, this at-the-money call option rose by just 10.75 index points.
As is evident in the table, as the strike price of a call option is raised,
its price declines
as does its sensitivity
to movements in the price of the underlying futures.
Choosing the Strike Price
This requires balancing risk with potential return. The former is simply the cost or purchase price of the option
along with brokerage commission and other trading fees. For example, if you want to risk at most no more than $1,000
on a December E-mini S&P 500 call option, then only those options having a strike price of 1110 or higher would be acceptable.
The potential return is based upon your expectation of how far E-mini S&P 500 prices will rally. A useful reference is the
break-even price.
The break-even price of a call option
is calculated by adding the option cost and paid trading fees to the strike price.
Consider, for example, the December E-mini S&P 500 call option struck at 1100. If it is purchased at the settlement price shown, then the break-even
price of the December futures at option expiration is calculated as:
1100 + 24.50 + fee value = 1124.5 + fee value.
At option expiration, December E-mini S&P 500 futures must be above this break-even price in order to
profit on the option trade.
So, you will only consider call options that have a break-even price below the price to which you expect
E-mini S&P 500 will rally. For example, let's say that you do not expect the December futures to rally much above 1150 by option expiration.
Based on this, you would only consider buying call options having a strike price of 1140 or lower since otherwise the break-even price
is too high.
What remains is the range of acceptable options. In this case, for an investment of at most $1,000 and with an expectation that December
E-mini S&P 500 will rally to around 1150 by option expiration, the call options having a strike price within the range of 1110 to 1140
would be acceptable to purchase.
After the purchase, you will need to manage the option position.
What if there are no remaining options that are acceptable after considering your desired risk and price expectation? Then you
can consider buying a more expensive call option and manage the risk, or
you can consider buying a bull call spread.
Bull Call Spread
When buying a bull call spread, both strike prices should be below the price to which
you anticipate the futures will rise by the time the options expire, in this case, 1150. Based on this, there are several spreads
that can be purchased. For example, the 1120/1140 bull call spread has a value of 15.50 - 9.00 = 6.50 = $325 plus commission and fees.
If December E-mini S&P 500 futures is above 1140 at the time of option expiration, then this spread will close
at its maximum value of $1,000 (calculated as 20 points x $50 per point). If E-mini S&P 500 is below 1120, then this spread will expire worthless.
Stepping down the strike prices will increase marginally the cost of the spread, but the chance of the maximum value
being earned is greater since E-mini S&P 500 need not rise so far. For example, the 1100/1120 bull call spread has a value
of 24.50 - 15.50 = 9.00 = $450 plus commission and fees. E-mini S&P 500 need only be above 1120 at the time of option expiration
to earn the $1,000 maximum value of the spread. If E-mini S&P 500 is below 1100, then this spread will expire worthless.
As you can see, spreads can be constructed at relatively little expense. You can risk more on a spread in return for greater
potential payout by increasing the gap between the two strike prices. For example, the 1100/1140
bull call spread has a value of 24.50 - 9.00 = 15.50 = $775 plus commission and fees but the maximum value is $2,000
and will be earned if December E-mini S&P 500 futures is above 1140 at the time of option expiration.
Because the market for option spreads is generally less active than the market for individual options,
you will likely have to pay a slightly higher price in order to effect the purchase. After the purchase,
you will need to manage the option spread position.
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