E-MINI OPTIONS: BUYING PUTS
Let's say you believe that the E-mini® S&P 500® is extemely overbought relative to the underlying economic fundamentals.
While prices have recently recovered from a dip, you believe that the 1100 index level provides solid resistance to any further appreciation
and expect the market to drop back. (See chart at right.) The drop could be quick and sharp and you are considering
buying an E-mini S&P 500 put option to profit should this sell-off happen.
The first step of the
purchase decision
is to determine the maturity of the put option: it must be long enough to capture the anticipated price drop.
The December 2009 E-mini S&P 500 put 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 put 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 put option struck at 1090 settled at 28.50 index points. The dollar value
of this option is $50 x 28.50 = $1,425. This put 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 pushing all put option prices lower but that the option prices moved by less
than this amount. In fact, this at-the-money put option fell by just 14.50 index points.
As is evident in the table, as the strike price of a put option is raised,
its price increases
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 put option, then only those options having a strike price of 1065 or lower 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 put option
is calculated by subtracting the option cost and paid trading fees from the strike price.
Consider, for example, the December E-mini S&P 500 put option struck at 1075. If it is purchased at the settlement price shown, then the break-even
price of the December futures at option expiration is calculated as:
1075 - 22.50 - fee value = 1052.50 - fee value.
At option expiration, December E-mini S&P 500 futures must be below this break-even price in order to
profit on the option trade.
So, you will only consider put options that have a break-even price above the price to which you expect
E-mini S&P 500 will fall. For example, let's say that you do not expect the December futures to fall much below 1030 by option expiration which is
the area of last support on the chart above.
Based on this, you would only consider buying put options having a strike price of 1050 or higher since otherwise the break-even price
is too low.
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 fall to about 1030 by option expiration, the put options having a strike price within the range of 1050 to 1065
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 put option and manage the risk, or
you can consider buying a bear put spread.
Bear Put Spread
When buying a bear put spread, both strike prices should be above the price to which
you anticipate the futures will fall by the time the options expire, in this case, 1030. Based on this, there are several spreads
that can be purchased. For example, the 1040/1060 bear put spread has a value of 18.00 - 13.25 = 4.75 = $237.50 plus commission and fees.
If December E-mini S&P 500 futures is below 1040 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 above 1060, then this spread will expire worthless.
Stepping up 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 fall so far. For example, the 1060/1080 bear put spread has a value
of 24.50 - 18.00 = 6.50 = $325 plus commission and fees. E-mini S&P 500 need only fall below 1060 at the time of option expiration
to earn the $1,000 maximum value of the spread. If E-mini S&P 500 is above 1080, 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 1040/1080
bear put spread has a value of 24.50 - 13.25 = 11.25 = $562.50 plus commission and fees but the maximum value is $2,000
and will be earned if December E-mini S&P 500 futures is below 1040 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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