Options on the Nasdaq-100 index allow investors and traders to construct nearly any profit profile they desire by entering an option position which will make money if the Nasdaq-100 goes up, down, or nowhere at all.
This ability makes options unique and a necessary tool for any investor. An important element of picking the right structure is recognizing that a directional trade can be executed so that it collects option premium or such that it pays option premium.
For example, when selling a call option spread a trader will sell a call option and limit the risk inherent in that short call option position by buying a call option with the same expiration date but a higher strike price. Conversely, when buying a call option spread a trader will buy a call and reduce the cost of the trade by selling a call option with the same expiration date but a higher strike price.
When buying an NDX call spread the maximum risk is the net premium paid for the spread and the maximum potential profit is the width of the spread minus the premium paid. When selling an NDX call spread the maximum risk is the width of the spread minus the net premium received while the maximum profit is the net premium received. You can see this below for an example NDX call spread.
Near the close of trading on Thursday, January 16, the Nasdaq-100 index was at 9125.00 while the February 9200 strike call was worth approximately 117.00 and the 9300 strike call was worth 72.00. For this example we’ll ignore the impact of the bid/ask spread.
The ability to satisfy any directional thesis makes call spreads particularly useful but there are a couple of issues to consider.
First, because so many investors like to sell covered calls to generate additional return, out-of-the-money call options, like the 9300 strike call in our example, tend to see their price pressured by those sellers. The implied volatility, the best expression of the cost of the option, is likely to be lower than that of the call which is close to at-the-money (the 9200 strike call in our example).
Second, one good way to analyze the cost of a call spread is to compare the cost to the width of the spread. In our example, the spread cost 45.00 but the spread is just 100.00 points wide. That spread is fully priced and any trader who was bearish to neutral should consider selling that spread. The maximum loss from selling that spread at 45.00 would be 55.00 but that loss would be realized only if the Nasdaq-100 was above the 9300 strike price at the February expiration as you can see below.
Nasdaq-100 index option spreads are a great tool and the investors and traders who aren’t using them are ignoring an opportunity to expand the payoff profiles they enjoy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.