Playing the Broad Market

By: Jon Najarian

The following is an excerpt from Jon Najarian's How I Trade Options

Individual stocks aren’t the only way to participate in the options market. The most efficient way you can play in the broader market is through index options. Increasingly, index options, which at one time, were used mostly by institutions to hedge portfolios, present an opportunity for retail investors.

In 1983, 10 years after the founding of the CBOE, the Exchange launched options on broad-based stock indexes. The first was an index of 100 of the biggest capitalized stocks listed on the CBOE and dubbed the Options Exchange Index, called by some of the Standard & Poor's 100 Index, which as the ticker symbol OEX. Seventeen years later, the OEX was still one of the most active index products on the market, trading an average of more than 130,000 contracts per day in 1999. The CBOE also trades options on the Standard & Poor's 500 index (SPX), which is based on the current or "cash" value of the S&P 500. (Note: This should not be confused with the options on S&P 500 futures contract, which trades at the Chicago Mercantile Exchange, where S&P futures are also traded.) 

For years before the launch of these products, indexes had been tracked and traded by institutions. But, most of that trade had occurred without a consolidated market. For instance, a customer would call an investment banking firm or trading company such as Goldman Sachs and ask for a "market" for cash value of the S&P 500. Goldman Sachs would quote a price at which it would buy the future price of the S&P 500 if the customer were selling, or the price it would sell the future price of the S&P 500 if the customer were buying. A transaction would be conducted which was off-exchange or over-the-counter (OTC).

But that kind of transaction, which still takes place in certain customized options and other off-the-exchange products, presented a large risk, known as contra-party risk. That means, by doing an over-the-counter trade, you have to bear the full credit risk of the person or party with whom you traded. Thus, if that other party had other obligations that caused losses, it might not be able to fulfill the obligation to you under the terms of the trade you made. Likewise, that other party had to deal with your potential credit risks, in case the situation arose that you could not financially fulfill your obligations.

This credit risk posed by party-to-party, over-the-counter trades and the sheer size of the market for index options were the catalysts that prompted the creation of options exchanges in the first place. Before the exchanges were created, options on individual stocks had traded over-the-counter for years. Likewise, the catalyst for index options was partially the burgeoning OTC trading of index options, as well as the initial success of the index futures contracts listed first by the Kansas City Board of Trade, which brought the Value Line Index and the Chicago Mercantile Exchange's subsequent listing of the S&P 500 futures contract. Since indexes are generally made up of anywhere from 10 to 1,000 stocks, over-the-counter trading of these options dwarfed the dollar-value – and, therefore, the potential risk – of equity options trading.

For example, let's say IBM is trading at $105 a share. The S&P 500 might be trading at $1,450 a share. That would be $1,450 times 250. (When the S&P Index contract was launched, the multiplier for the value of the overall S&P contract was 500. Years later the size of the S&P contract was cut in half, reducing the multiplier to 250.) That means that a single contract for the S&P 500 would represent an underlying value of $1,450 times 250, or $362,500. By the same token, at $105 a share, a single contract trade in IBM would represent an underlying value of $105 times 100, or $10,500. 

That difference - $362,500 for one S&P contract versus about $10,000 for one equity contract – underscores the need for contra-party credit risk protection for index options trading – the size can get pretty scary really fast. The need for protection from contra party risk was one of the reasons to list index options, and the other was the often forgotten individual investor. The OTC index option market left the retail investor out in the cold, as virtually no retail customer was on the radar screens of the investment banks, and the trading houses that made markets in the OTC index options. The early successes and relative contract size of both the KC Value Line future and S&P 500 future at the CME indicated the retail investor was willing to invest in index futures. And if they were willing to trade futures, it was only a matter of time before index options took hold as well.