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Last week I bought put options on the Dow Jones Industrial Average to protect my portfolio against a worldwide slip in equities. I bought options giving me the right but not the obligation to sell the Dow at an index level of 17,500. With the Dow currently over 24,700 this instrument is an extreme form of an “out of the money” option. That is, it currently has no intrinsic value and will not have any unless the market moves very significantly, i.e. while I could theoretically sell the index at 17,500 that would be silly given that it can be sold at over 24,700.
The options are valid until 21st September 2018. If the market stays above 17,500 between now and then my options will expire worthless and the $119 per contract I paid as a premium to buy the right to sell at 17,500 will have been wasted (in the same way as insurance premiums are “wasted” when you don’t claim anything back).
If however the Dow goes to 16,000 each of my options has an intrinsic value of 15 points x $100 = $1,500. That is a $1,381 profit, an increase of 11.6 times.
How the Dow options work
The “underlying” for index options is not the straight forward Dow average, say 23,000 or 18,000. Rather, it is one-hundredth of the true Dow. Thus the option “strike price” of 230 or 180 represents the Dow at 23,000 or 18,000.
Likewise the premiums you have to pay to buy the right to say buy the Dow (a “call option”) at say 20,000 (a 200 call) at any time up to say late June are expressed in one-hundredths of what you actually pay.
My option
To bring it back to my actions: I haven’t bought the right to buy the Dow, but to sell it; thus I bought a put option, not a call option.
The strike price is expressed as a September 175 put at a price of $1.19 per contract. But because of the convention of 100 points on the Dow being worth 1 point in options, I actually paid $119 per contract. I have the right to sell the market at any time up to 21st September 2018 at a price of 175 (which is really 17,500).
With each single “point” on a contract labelled 175 worth $100 if the underlying moved to a Dow of 17,400, in option terms that would be 174.
This is one point below the 175 at which my option can be “exercised” through……………….
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