Participate in an Increasing Index Level with Limited Downside Risk
Please note: Commission, dividends, margins, taxes and other transaction charges have not been included in the following examples. However, these costs can have a significant effect on expected returns and should be considered. Because of the importance of tax considerations to all options transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated options transactions.
Index XYZ is currently at 500. An investor could purchase one three-month XYZ 505 call, which represents the right to purchase the underlying index at a level of 505, for a quoted price of $11. The total cost for the call would be: $11 x 100 contract multiplier = $1,100. The underlying asset value for this option is not shares of stock, but rather the current index level x 100 multiplier = $50,000. Instead of committing $50,000 to a bullish, speculative outlook, spending only $1,100 for the purchase of one call would leave a balance of $48,900 that could then be invested elsewhere.
By purchasing the call the investor is saying that by expiration he anticipates index XYZ to have risen above the break-even point: $505 strike price + $11 (the option premium paid), or an XYZ level of 516. The investor’s profit potential is unlimited as XYZ’s level continues to rise above 516. The risk for the call purchase is limited entirely to the total $1,100 premium paid for the contract no matter how low XYZ declines.
Before expiration, if the call purchase becomes profitable the investor is free to sell the option in the marketplace to realize this gain. On the other hand, if the investor’s bullish outlook proves incorrect and XYZ declines in price, the call might be sold to realize a loss less than the maximum.
Consider three possible scenarios at expiration:
- XYZ closes above the break-even point
- XYZ closes between the strike price and the break-even point
- XYZ closes below the strike price