Index options trading strategies to consider during market volatility

[Music] [Music] thanks for tuning in everyone great to have you here with us i'm your host brian rogers and there are many investors out there who like to take a more passive approach to investing for example they might invest in a broader market like the s p tsx compassion index or the s p 500 index they're often hoping the index's diversification will offer lower trading risk and volatility than individual stocks might and that may be especially true during times when market volatility is running high now investors typically gain exposure to an index by purchasing a mutual fund or an exchange traded fund that aim to mimic its performance that's because you can't buy an index directly after all it's simply a tool to measure the performance of the the securities it tracks but it's a little different for options traders who want to gain exposure to those broader markets there are options available that let them trade against many indexes directly instead of using a proxy like an index etf for instance many traders simply aren't aware that they exist well we're going to learn all about these index options with some help from tony zhang chief strategist at options play he has more than a decade of experience in the options market and tony will explain what options index options are and how they differ from more standard equity options then he'll discuss some trading strategies for index options that may work well during higher market volatility and he'll share some of his best practices for each strategy along the way nice to speak with you tony we appreciate you taking the time thank you so much for having me brian looking forward uh to doing the session talking a little bit about indices and the options that you can trade on them oh excellent all right well now let's dive into our discussion first things first what is an index option uh that's a really great question i could think most investors as you say are familiar with indices from a market tracking purpose right we talk about it on tv we see it in newspapers it gives us a sense for whether markets are up or down on a given day and most of the major indices like the s p 500 the nasdaq 100 or as you said the tsx composite or tsx 60 are from are ones that we track in north america to give us a sense for how well the equity markets are doing now many investors that are looking for exposure to kind of a broader equity market might use as you say a mutual fund or etf vehicle in order to access or gain exposure to these indices but an index option is another way that you can access these indices through an option now for many investors that are trading soccer etf options you might be familiar with trading etf options on one of these etfs that track these indices what you might not know is that you can actually trade options on the index itself and there are going to be some primary differences between the vehicles even though you're getting exposure to largely what is a very very similar product or very highly correlated product there are some distinct differences from a practical perspective when you're trading an etf option and an index option that's actually exposed to the exact same index okay interesting so how does index options differ from trading stock or etf options first of all i think the biggest difference that i that investors need to be familiar with is the fact that index options are always cash settled that means that there's no physical delivery whether you're buying or selling an option you don't have to worry about being assigned at expiration or exercise if the call option or put option is in the money so whatever profits and losses that you have on the trade at expiration is simply debited or credited out of your account and we know that the vast majority of option contracts are closed before expiration which tells me that most investors are not interested in taking delivery or or being exercised on a call option so index options from my perspective are a little easier to manage because you don't have to worry about early assignment risk you don't have to worry about being exercised or assigned at expiration so they're also european style which is a primary difference because they cannot be exercised early this avoids early assignment and the fact that cash settled again really just makes them in my opinion a little easier to manage now one of the things that is different between the two contracts is that etf and stock options almost always are pm settled what that means is that they are settled based on the closing price on the expiration date there are some in index options especially the big contracts the full-size contracts these are what we traditionally call institutional type products that have am settlement a popular one here are vix index options they are all am settled that means that despite the fact that trading ceases the day before the expiration date the settlement price doesn't happen until the opening price of the expiration date and there's overnight risk that you're taking when you hold one of these contracts to expiration and lastly the settlement uh you know trading hours are also sometimes different not only trading hours but also multipliers stock and etf options we're used to 100 shares for every single contract at least for a standard contract well we're talking about index options we have seen some of them have different multipliers and some of them trade till 4 15 after hours so you have a little bit of an extended session when you're trading index options versus etf options and there are going to be some differences also between canada and u.s so be careful when you're or be cognizant that we're when you're trading these index options to look at the specifications of each contract and make sure you understand uh the differences between stock or etf which tend to be more standardized versus index options which traditionally were made as institutional products so there are there are variations between the different indices okay that's great that helps us understand the different i you know i really appreciate that tony one thing i was i was wondering though for the traders out there like why would they consider an index option over an index etf option uh that's a really great question and you know i talked about a few of the differences and like i said the cash settlement in european settlement from my perspective is one very distinct difference for specific strategies so you have certain option strategies that are more prone to let's say early assignment such as selling a credit spread so if you'd like selling credit spread on etf options you are taking not taking on that risk of being assigned early you are taking on the risk that you can get assigned on the short strike at expiration or what we call exercise risk so these are some of the things that if you are trading some of these strategies index options helps you avoid those risks and also index options in in the last few years we've seen an introduction of these micro index options or even mini index options so what they provide you with is exposure to the same index but actually at a smaller size so for example if you look at the uh the the uh the nasdaq 100 index the nasdaq 100 is currently trading at close to 12 500 that's a 1.2 million dollar contract so obviously not suitable for most retail traders but they also have a micro product which is 1 100 of the s of the nasdaq 100 which means that it's priced at about 125 dollars per share or about a 12 500 contract and if you compare that to a 30 000 uh qqq contract you're talking about a size that's roughly one-third the size so the index options not only give you potential benefits from a assignment risk perspective but also perhaps a little bit more flexibility especially for investors who have a smaller account all right yeah it seems like they've done a great job of adding some of those different products out there to make this available to everyone so that's great all right generally speaking how do index options typically behave during periods of higher market volatility compared to equity options what happens is that the implied volatility of an index actually will actually be slightly lower than the implied volatility of the individual stocks that make up that index and this is really because an index diversifies away single stock risk so depending on whether you're looking for volatility or you're trying to hopefully avoid some of that volatility index options can potentially give you a way to diversify away some of that additional volatility if let's say you are currently in a market condition where you want to avoid some volatility so it can give you a different uh exposure type to the same type of directional view that you might have on the broader markets but do so in a way through the index and also the other thing that we also think about you know during market volatility is liquidity and this is really something where me and my uh me and my research team have done quite a bit of research on looking at the execution quality of index options as things get more volatile and in this particular study we looked at the nasdaq 100 index options how close are executions to the midpoint and what surprised us was that actually during market volatility as things got more volatile we actually saw trades happen closer to the midpoint meaning the execution uh quality the uh these um the slippage if you will or the transaction cost actually was reduced going into a higher volatility environment now i i do want to just say that you know causation is a correlation does not mean causation it's not to say that when things are more volatile you all you always get better execution quality it probably just means that when things are more volatile people tend to pay more attention to where they're getting filled or maybe uh being more cognizant of transaction costs as things get more volatile but it really just speaks to the deep liquidity that you get access to from these types of products where when things get more volatile because indices are literally the most vastly traded products in the world some of the most liquid products in the world you tend to see quality execution in these products despite the fact when volatility gets quite extreme okay great so you've shared with me some trading strategies for index options that you would consider during periods of higher market volatility the first one is buying a call or a put option on an index why might this strategy make sense during volatile market conditions what you're trying to achieve when you're buying a simple single leg option strategy like a call or put is to gain what we call convexity and that means that if the directional if the if the market moves in the direction that you expected to you have unlimited potential or unlimited profit potential in that specific direction but on the flip side if you are incorrect in the directional view uh then you have limited risk so this effectively increasing your leverage as things get in your favor but at the same time not having that leverage hurt you if the trade goes against you that's what we call convexity or asymmetrical risk that's the primary reason i think most investors at first are attracted to using options as an asset class who doesn't want to get paid when they're right but also have limited risk when they're wrong now there are some trade-offs to this type of asymmetrical risk and that's the fact that you have to pay a premium in order to get this asymmetrical risk so it's very important to understand how much premium do you have to pay to get access to this type of exposure and that's really where the devil is in the details the asymmetrical risk profile is what's attractive but the thing that you have to be paying attention to is which option are you purchasing how much does it cost and what are the trade-offs what are the risks with doing so it's important to understand that call options or put options require the stock or index to move in a specific direction before you're even profitable and you have to understand how much does the stock or index need to move before it's profitable to help you decide whether it's a right investment for your portfolio or your outlook on the underlying market or stock all right can you can you share an example of buying an index call option i will bring up the thinkorswim platform and let's take a look at one of these micro indices together so we're going to look at xmd which is the nasdaq 100 micro index so this is taking the nasdaq 100 index and effectively dividing it by a hundred and let's say i look at the august 120 call options and i'm using this because it's roughly a 50 60 i usually like to pick strike prices that are about a 60 delta as a starting point so i'm actually going to use the 121s and as you can see this is trading at 510 by 525 so if i'm looking at buying this call option i'm looking at the august 121 call option that will cost five dollars and twenty cents and i can certainly look at annual analyzing this trade to give me a sense for uh the risk profile and this is really something that helps me better understand uh this particular trade and what you can see here is my break even price on this on the strategy is about 126.20 um so the index has to reach about 120 620 or so or 12620 by the expiration date which is in 30 days and remember the index is currently trading around 122. so this is this this index has to move four dollars higher in order for this strategy to be profitable at expiration now if the index does go beyond 125 or 126.20 i have unlimited

gains here to the upside but to the downside no matter what happens the most i can lose is the 500 and roughly uh five dollars and twenty cents that i pay for this call option so this gives me limited risk of the downside which you know on a hundred and twenty two dollar index i'm risking five dollars for five dollars and twenty cents which is about four percent of the index values so no matter what happens even if the markets drop another ten percent over the next month i'm only going to risk four percent of the index in order to take that upside exposure in this particular case unlimited upside exposure for xnd so what are some of the key considerations when buying index call options during volatile markets so what i'm really considering when i'm looking at these options is how expensive these options are whenever you're buying an option you you want to buy low and sell high so you want to consider whether or not you perhaps might be overpaying for the option because the option price tells you how far the stock needs to move or how far the index has to move before the strategy is profitable so the most important thing to pay attention to when you're buying an option is how much you are paying if i'm buying an index option i will usually like to go out a little further out in time and one of the reasons i like to go a little further out in time is because of the time premium as you can see if i go out to september i can buy the same 120 call option or 121 call option for 6.90 so what i'm doing here instead of paying five dollars and twenty cents yes i'm paying a little bit more i'm paying about a dollar seventy more but i'm getting a whole extra month in time so paying an extra 1.70 i can get a whole another month and if i go even out to october just to show you uh just to give you a sense here if i go out to october and i buy the 120 calls it only cost me 8.60 so even further uh less premium than i'm paying for each additional month so as from my perspective when i'm using these indices to gain exposure longer term in some of these um uh in the broader markets my preference is to actually go a little further out in time because the time decay that i'm paying per day is actually less so if i'm looking at buying this call option here at the midpoint and i analyze this particular trade what you'll see here and so as you can see the august was 5.20 the october's is dollars and sixty cents so i'm getting three times or twenty three times the amount of time for less than double the price and this is really the primary thing that i'm paying attention to is how much time premium am i paying per day when i buy a call option uh so the october's obviously i'm paying significantly less per day because i'm paying less than double what i'm paying for a 30 day option okay that's fantastic thanks so much tony hey you're such a fountain of knowledge on this i i would be doing my audience a disservice we didn't crank it up a little bit further and we wanted to ask you about credit spreads so i wanted to take a look into using a credit spread with index options so how does a credit sped spread work and why could index options potentially work well for this type of strategy so a credit spread is an interesting strategy because it's it's what we call a fairly forgiving strategy and a lot of options selling strategies are somewhat forgiving and i'll explain as to what what i mean in the examples as to what forgiving means but what you're doing is you're primarily selling an option and then when you're when you're trading a credit thread you're selling an at the money or or a caller put and then you're buying a further out of the money caller put against it and the primary reason for doing so is so that you have premium that you collect so your short time decay so time decay is working in your favor but when you're selling a credit spread you have both limited risk and limited reward this gives i think for a lot of investors who's starting out a bit more guard rails around how much money you can potentially make and how much money you can potentially lose rather than some of the other strategies where you could potentially have unlimited gains or unlimited losses that's just a little bit more difficult conceptually to grasp as to how can i make money how can i lose money where do i make money and how much money do i lose when you're trading a credit spread it's defined not only how much you can make and how much you can lose and i think that many times makes it a little easier for someone who's starting out because i hear a lot from investors saying you know i don't understand an option because i don't i don't understand the risk or i don't understand the rewards so credit score really makes it simple to understand how much you can make how much you can lose and a credit spread is really a directional play a fairly neutral but directional play which means that you can make money if the trade goes in your favor but you can also make money if the stock doesn't move at all or the index doesn't move at all and that's really an interesting strategy for a lot of investors who are starting out who may not feel very strong in their ability to call the direction of the market right they might see an overall trend and they can say i can understand the trend but i'm not very good at saying i think the stock or this index is going to be at a specific price on a specific day what you tend to need to have when you're buying a call or buying a put but when you just have a general sense for the trend a credit spread may be better suited because it's going to allow you to turn a profit if you have the trend correct or even if the trend just doesn't continue but the index or stock stays where it is you can still be profitable you're only going to lose money if you absolutely get the directional view wrong so from that perspective it's forgiving and i think a lot of beginners tend to like that from both the directional perspective and also understanding the risk and reward perspective a credit spread the main driver of that call of that strategy is a short call or a short put um so it's it's it's for traders who are looking to collect premium but we know that if you sold a call or put naked you're taking on either unlimited risk or very substantial amount of risk not to mention you need a fair amount of capital in order to sell that short call or short put so a credit spread gives you a risk profile very similar to selling that short call or short put but does so in a way with limited risk and does so in a way so that you have it requires a fairly small amount of capital to get started so what we're doing here with putting up a put credit spread is we're going to sell and at the money put and we're going to use let's say about a 30-day expiration date which for here is about an august 20 26 expiration and what we're going to do is we're going to sell that 128 put the first out of the money put option because the out the at the money put options are going to have the highest amount of extrinsic value and when you're selling an option you want to sell the most amount of extrinsic value as possible so that's why we're choosing that at the money put but like i said because when you sell an outright put option it requires a fair amount of margin it has a fair amount of risk so one of the things that we can do to reduce the amount of margin requirement and the risk is to buy an out of the money put option and i tend to find that if you use about a 25 delta strike price that's a good place to start in terms of buying a put so if we're selling the 128 i would look at maybe buying about the 122 here which is about the 25 delta and if you construct that together you have a credit spread that is six dollars wide the distance between the 128 and the 122. and as you can hear as you can see here if i if i trade this type of credit spread i'm collecting a dollar 85 which is just a little bit under two dollars which is one-third of the distance of the vertical width and what we can do is we can take a look at this particular trade and analyze this using the analyze tab um and taking a look at this particular trade and the risk profile and what you're going to see is that it's similar to buying a call spread in terms of you have limited potential gains limited potential losses and it's profitable if this if the index in this particular case stays where it is or rises and that's really what's interesting about a credit spread because once you trade any strategy three things can possibly happen the stock or index can move higher lower or it trades just where it is and in two of those three scenarios this strategy will be profitable so if you are correct and the directional view of this put credit spread and the index continues to move higher you'll be profitable but what's really interesting is that even if the index doesn't move if it just stays where it is you'll still be profitable and even if the index moves a little bit against you you will also see some profits on this particular trade only if the index was substantially lower do you start to see losses and the losses here are limited to that what you if you take the distance between the two strikes which is 120 and 122 that's six dollars you subtract the 1.85 that you

collected and premium on this credit spread the rest of that is going to be your total risk and this is a great way to think about these these types of strategies is their limited risk limited reward they're relatively forgiving because you you are profitable in two out of three possible scenarios but it is a strategy that has what we call negative risk to reward ratio so the risk that you take is going to be higher than the potential reward that you make and that's the trade-off that you have when you have a higher probability of success strategy where you'll be profitable two out of the three different scenarios that could happen and what's interesting about a credit spread for a lot of traders who may be new to options is that you usually think of options as requiring the stock to do something before or the index do something before you're profitable with a credit spread in this particular example the index can just stay where it is and you can still be profitable if x and d just simply stays put and doesn't move doesn't move higher doesn't move lower i still make the full profit that's the interesting part about selling options is that if the index or the stock that you're selling an option on doesn't move you'll be profitable and that's an interesting trade for a lot of investors um and in addition to that what you're also doing when you're selling a credit spread is your short time decay so time decay is actually working in your favor okay so you briefly touched on what you would use as a rule of thumb for a strike price and an expiration date can you review that again briefly tony and also is there any other best practices you would use when doing a credit spread with an index option yeah absolutely so like i said expiration dates usually between 30 to 45 days out we like to sell and at the money call our put depending on whether you're bullish or bearish and the reason for that is to maximize the amount of extrinsic value that you're capturing on that credit spread and to offset the risk of selling that at the money caller but we're buying back a 25 delta caller put depending on whether you're bullish or bearish to construct that credit spread now we generally have a bunch of rules for managing these credit spreads when you're doing them on a stock or in or etf because when you're selling a credit spread on a stock or etf you have assignment risk uh you have extras you have assignment risk and you have early assignment risk so we have a bunch of rules to take profit early to cut losses early and to simply roll them as you get to the last two weeks of expiration um so you know we would typically take profit at 50 of the max gain we would cut our losses if we lost 100 of the max gain and we would we would start rolling these trades about two weeks from expiration but when you're trading this on an index option because they're european and they're cash settled you don't have early assignment risk and you don't have an assignment risk at all so what that means is that the only rule that you really have to stick to when when these when you trade these credit threads on an index option is really that stop loss rule you don't have to take profits early and you don't have to roll them two weeks from expiration because you don't have those risks so the only thing you really have to monitor is if the trades not going in your favor to simply cut losses and move on to the next trade otherwise they are much much easier to manage using an index option than doing them the corresponding trade on an etf option all right well this was a fascinating conversation tony thanks so much for sharing your approach to trading index options with us we're going to have to leave our conversation there but we're going to pick up things in our live q a so let's head over there to hear what our viewers want to learn more about you

2022-08-25 13:42

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