Enhanced Indexing Strategies: Utilizing Futures and Options to Achieve Higher Performance

CHAPTER 4

Capturing Index Appreciation with Calls

This chapter shows how to use various call options to capture index appreciation. The first step is to develop an understanding of how call options are priced. While most finance professionals are familiar with the Black-Scholes model, this chapter presents a simple alternative explanation that can help investors better appreciate option pricing in the context of hedging, sharing, and transferring risk.

The bulk of the chapter is devoted to comparing the expected profitability of various options by applying the Black-Scholes model to the appreciation expected over the life of the option for both short-term and long-term and in-the-money and out-of-the-money options. The analysis shows that some options are very good at capturing appreciation with low risk, while others are expected to have negative value.

The pricing and expected value of call options is very dependent upon volatility, both implied and realized, and throughout this chapter the relationship is examined in depth. An approach is also modeled in which out-of-the-money options are held until they are at the money in order to show the pitfalls of predefined price targets and related trading strategies.

INTUITIVE OPTION PRICING

The Black-Scholes option pricing model allows investors and financial professionals to quickly price any option by providing just five inputs: the price of the underlying security, the volatility, the days to expiry, the expected dividends, ...