Option Investor
Educational Article

Long lives the Index Option

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Now I know you all have been through this one. You have done all your homework; you've selected some great companies or issues. You even got some great fills, when you put on your long positions. Those THG incorporated July 30 Calls you bought really look primed for a big move. You hear a great pre market report about the general economy and you can't wait until the bell rings signaling the opening of the trading day. What an opening, the Dow Jones Industrial averages open up strongly 120 points! You are on your way! Then you see the quote on your THG down .60 to 32 a share. " How can this be!",you exclaim. I need say no more. We all know how this could be. We have all selected a stock that at one time or another just didn't move with the direction of the overall market. What makes it even worse is when that stock is a member of an index that has a positive movement for the day. There are very few things that are worse for a trader who is long, then beginning his day with a bullish start to the market, only to see his stock headed in the opposite direction or even going in no direction at all. Now you also know, when given a choice between more then one issue, it becomes difficult to narrow that selection down to the optimum of all trades. In the real world, it just doesn't happen. But if becomes a necessity to be able to cash in on winning trades when the market goes your way, because there are so many times when the market isn't quite as cooperative. To avoid this tragedy of miscalculation, one needs to consider an alternative. This alternative should give one the assurance that if the general market environment is positive that his long position will be positive as well. Conversely, if the market environment is negative his Long call position should also benefit. Once again, there are very few things more frustrating to have, for example, a Standard and Poors 100 company long and the index sharply up, while your stock selection within the index is trading lower. The use of the Index option allows one to participate in the general direction of the market momentum. You can be pretty certain that the DJIA, Standard and Poors and other indexes are all going to be up if you get pre market indications of some good economic news. However, you are less likely to get that type of movement from you individual stock, even if it is part of the index. Remember, the Indexes that are up are made up of winners and losers. How many times have you heard the Dow Jones Industrials being up and finding 18 issues up and 12 issues down or 22 issues up and 8 down? The combinations are endless. The issue here however is about profitability. It is tough make a profitable trade, when you have general bad economic news. Remember no matter how good the news is about your individual stock, the overall net effect of the market will still weight on its overall performance for the day. For example, there is a chance that even if your stock is a member of a particular index and your index is up, there is no guarantee that your particular issue will be up.


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Table 1: Hypothetical Index: THE BIG TEN INDEX SYM: BTI 36 + 0.70

The table above shows a hypothetical index called the BIG TEN INDEX trading at 36 up + 0.70 with it's the activity of the ten members that make up this hypothetical index.
In this case our THG stock is down (- 0.25), which is a member of the BIG TEN INDEX.
On the other hand, you can be sure that if there is general good news surrounding the market that the overall index is going to be up. Hence if you are buying long Index option calls you don't have to worry about what your stock is doing (especially if it is a member of the index) you just know that your Index is going to participate in the overall upward movement of the market and not have to worry if your individual stock will be one of the advancing issues within the index or one of those decliners.

The Pragmatic question that you should ask yourself is the following: Would it make more sense to believe that in the morning if you had positive economic indications that the Indexes (DJIA, OEX, SPX, etc.) would have a better chance of being up than any one particular issue?

I hope you concur with me, that the answer is yes.

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