After mastering the distinctions between stock index options and stock options, and discovering which type of investor each one benefits, you're ready for the next step. Today, we'll dive into two critical insights essential for successful investing in stock index options. Grasping these insights is your gateway to unlocking the full profit potential of options trading.
American vs. European Options: When to Secure Your Gains
Options are divided into European and American styles, with the main difference being the exercise time. Let's look at an interesting example: Suppose you buy a call option on a stock index on June 1st this year. The current index is at 1000 points, with an expiration date of June 30th. Due to your strong investment skills, you accurately predict the index trend. On June 5th, the index surges to 2000 points, and your call option value skyrockets, making you several times the profit in just a few days!
However, a new problem arises. The index has surged in the short term, but there's still a long time until the expiration date. You're worried that the index might pull back in the coming days, eroding your profits. If it's an American option, you can exercise it immediately to lock in your gains. But if it's a European option, you must wait until June 30th to exercise, which brings some uncertainty. Nevertheless, even with European options, you can sell the option in the market at any time to secure your profits.
Theoretically, American options might be more expensive than European options because they include the right of early exercise. However, in actual trading, especially for non-dividend-paying underlying assets, the price difference between the two may not be significant. Therefore, when investing in options, you need to pay attention to whether you're buying European or American options. The SPX, SPXW, VIX, and VIXW options we mentioned earlier are all European options.
Read More: Strike Price? Expiry Date? Understand These Key Terms
Asymmetric Risks of Buying and Selling Index Options
Besides the option type, we also need to focus on the direction of option trading. Simply put, buying options has controllable risk, while selling options can potentially face unlimited losses in extreme cases.
Let's revisit our previous example. You buy a call option on June 1st for $50, with the index currently at 1000 points and a strike price of 1100 points. Unfortunately, your luck turns bad, and the index plummets to 500 points. Your option becomes almost worthless, but at least your maximum loss is limited to the $50 option premium.
Now, imagine another scenario. The index has fallen to 500 points, and you think it will continue to decline. So you sell a call option with a strike price of 600 points and receive a premium. Unfortunately, the index quickly rebounds to 1000 points. This means others have the right to buy the index from you at 600 points. Your actual loss is 400 points (1000-600) minus the premium you received. Theoretically, the index could rise to 1500 points, 2000 points, or even higher, potentially increasing your losses further. In general, don't attempt to sell options unless you're very confident.
