On Thursday I bought put options on the Dow Jones Industry Average Index. The exercise price is 190 and this right to exercise expires on the third Friday in September. I’ll explain.
Let’s start with what a put option is: a right, but not an obligation, to sell the underlying at a fixed price at some point in the future or over a period of time.
Applying that to the Dow: the underlying, i.e. the DJIA stands at 25,200 today. A put option gives me the right to sell the Dow at a set price in September.
A slight complication: instead of the straightforward Dow the DJIA number is divided by 100 for the option contract.
Thus if the real Dow is at 25,200 the option that is “at the money” is expressed as 252 (an at the money option has an exercise price the same as the current market price).
Each of those points is worth $100.
I’ll illustrate with the put that I purchased on Thursday: I bought the right but not the obligation to sell at 190.
If I was to go ahead and exercise my right I would fork out 190 x $100 = $19,000.
But, with index options I do not have to buy the underlying because these are what is called “cash settled”.
That is, only the difference between 190 and the value at expiry is paid over in cash (I don’t sell 30 different company shares).
Obviously, I would not want to exercise the right to sell at 190 when the market is at 252. This means that the option does not have intrinsic value (it is “out of the money”).
If I had bought a 260 put option instead I would have the right to sell at 260 x $100 = $26,000 and I could buy that index at 252 x $100 = £25,200.
This put option has intrinsic value of 8 points or $800 (it is “in the money”).
But such an option costs a lot more than the heavily out of the money one I did buy. I paid 1.33 points for the right to sell at 190.
Those 190 points are worth 190 x $100 = $19,000, whereas my option cost 1.33 x $100 = $133. This is only 0.5% of the underlying.
I have between now and the third Friday in September for my option to gain some intrinsic value. It will not do so if the Dow stays above 19,000.
So, if the underlying fell to 180 (that is 18,000 on the real Dow) I would have the right to sell at 190 while being able to “buy” at 180. The market organiser (CBOE in Chicago) will cash settle with me for 10 points per contract (190 – 180), each point worth $100, thus sending me $1,000 in September.
Thus, I have a highly geared position on the Dow. For a large range of Dow values in September I receive nothing, but when (or, rather, IF) the Dow falls below 19,000 I start to gain quite high percentages. If the Dow falls all the way to 14,000, off about 44% from its current level, then the amount I receive is thirty seven times the amount I put down as a premium – see table.
Real Dow in September | Dow for the purpose of option pricing | I can sell at | Number of points difference | Value of option | Percentage change for the 1.33 points x $100 = $133 paid for each option |
25,200 | 252 | 190 | negative | Expires worthless – all option premium lost | -100% |
19,000 | 190 | 190 | 0 | Expires worthless – all option premiu |
………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1