How to Buy Options on the Dow Jones

06/17/2015 8:00 am EST

Focus: OPTIONS

Elvis Picardo

Vice President - Research, Associate Portfolio Manager, Global Securities Corp.

Elvis Picardo, of Investopedia.com, explains why buying options on the Dow Jones is a good alternative to trading the ETF because of the substantially lower capital requirements for trading options, as long as one is familiar with the risks involved.

The easiest and most cost-effective avenue to trade the Dow Jones Industrial Average (DJIA) is through an exchange traded fund (ETF). One of the oldest ETFs is the SPDR Dow Jones Industrial Average ETF Trust (DIA), which tracks the DJIA and seeks to provide investment results that correspond to the price and yield performance of the index. As each DIA unit trades at approximately 1/100th the prevailing level of the Dow Jones Industrial Average, trading the DIA requires a substantial capital outlay. For instance, based on the May 13, 2015, level of about 18,100 for the DJIA index and a price of $181 for a DIA unit, a board lot would cost $18,100. If you have limited capital but want to trade the index, options on the Diamonds—the colloquial term for the DJIA ETF—might be a good way to go, assuming you know the risks involved in option trading. We demonstrate how to buy options on the DJIA in the following sections.

Types of Option Strategies

For the purposes of this exercise, we focus on the September 2015 options—which expire on September 18, 2015—on the Diamonds.

The emphasis here is on buying (or going long) options, so that your risk is limited to the premium paid for the options, rather than strategies that involve writing (or going short) options. Specifically, we focus on the following option strategies:

  • Long Call
  • Long Put
  • Long Bull Call Spread
  • Long Bear Put Spread

Note that these examples do not take into account trading commissions, which can significantly add to the cost of a trade.

Long Call on the DIA

Strategy: Long Call on the DJIA ETF (DIA)

Rationale: Bullish on the underlying index (the DJIA)

Option selected: September $183 Call

Current Price (bid/ask): 3.75 / $4.00

Maximum Risk: $4.00 (i.e., option premium paid)

Breakeven: DIA price of $187 by option expiry

Potential Reward: (Prevailing DIA price, breakeven price of $187)

Maximum Reward: Unlimited

You would buy or initiate a long position on a call if you were bullish on the underlying security. The all-time high on the DIA units at the time of writing was $182.68, which was reached on March 2, 2015, the same day that the DJIA index peaked at 18,288.63. A strike price of $183 means that you would be looking for the DJIA to surge past its March 2015 high by the September 18, 2015 expiration of the calls.

If the DIA units close below $183—which corresponds to a Dow Jones level of about 18,300—by option expiry, you would lose the premium of $4 that you paid for the calls. Your breakeven price on this option position is $187 (i.e., the strike price of $183 + $4 premium paid). What this means is that if the Diamonds close exactly at $187 on September 18, the calls would be trading at $4, which is the price that you paid for them. Assuming you sell them at $4 (just before the close of trading on September 18), you would recoup the $4 premium paid when you bought the calls and your only cost would be the commissions paid to open and close the option position.

NEXT PAGE: What if Those Unlikely Events Happen?

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Beyond the breakeven point of $187, the potential profit is theoretically unlimited. In the (unlikely) event that the Dow Jones soars to a level of say 20,000 by September 18, 2015, the DIA units would be trading at about $200. Your $183 call would be trading at around $17, for a tidy $13 profit or 325% gain on your call position.

Long Put on the DIA

Strategy: Long Put on the DJIA ETF (DIA)

Rationale: Bearish on the underlying index (the DJIA)

Option selected: September $175 Put

Current Price (bid/ask): $4.40 / $4.65

Maximum Risk: $4.65 (i.e., option premium paid)

Breakeven: DIA price of $170.35 by option expiry

Potential Reward: (Breakeven price of $170.35, prevailing DIA price)

Maximum Reward: $170.35

You would initiate a long put position if you were bearish on the underlying security. In this instance, you are looking for the Dow to decline to at least 17,500 by option expiry, which represents a 3.3% drop from its current trading level of 18,100.

If the DIA units close above $175—which corresponds to a Dow Jones level of about 17,500—by option expiry, you would lose the premium of $4.65 that you paid for the puts.

Your breakeven price on this option position is $170.35 (i.e., the strike price of $175 less $4.65 premium paid). Thus, if the Diamonds close exactly at $170.35 on September 18, the calls would be trading at your purchase price of $4.65. If you sell them at this price, you would break even, with the only cost incurred being the commissions paid to open and close the option position.

Beyond the breakeven point of $170.35, the potential profit is theoretically a maximum of $170.35, which would happen in the impossible event of the Diamonds dropping to $0 (which would require the DJIA index to also be trading at zero). Your put position would make money if the Diamonds are trading below $170.35 by expiry, which corresponds to an index level of about 17,035.

Let’s say the Dow Jones plunges to 16,500 by September 18, 2015. The Diamonds would be trading at $165—and the $175 puts would be priced around $10—for a potential $5.35 profit or 115% gain on your put position.

Long Bull Call Spread on the DIA

Strategy: Long Bull Call Spread on the DJIA ETF (DIA)

Rationale: Bullish on the Dow Jones, but want to reduce premium paid

Options selected: September $183 Call (long) and September $187 Call (short)

Current Price (bid/ask): 3.75 / $4.00 for $183 Call and $1.99 / $2.18 for $187 Call

Maximum Risk: $2.01 (i.e., net option premium paid)

Breakeven: DIA price of $185.01 by option expiry

Maximum Reward: $4 (i.e., the difference between the call strike prices) less net premium paid of $2.01

NEXT PAGE: Could This Reduce the Cost of an Option Position?

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The bull call spread is a vertical spread strategy that involves initiating a long position on a call option and a simultaneous short position on a call option with the same expiration but a higher strike price. The objective of this strategy is to capitalize on a bullish view on the underlying security, but at a lower cost than an outright long call position. This is achieved through the premium received on the short call position.

In this example, the net premium paid is $2.01 (i.e., premium paid of $4 for the $183 long call position less the premium received of $1.99 on the short call position). Note that you pay the ask price when you buy or go long on an option and receive the bid price when you sell or go short on an option.

Your breakeven price in this example is at a price of $185.01 (i.e., the strike price of $183 on the long call + $2.01 in net premium paid). If the Diamonds are trading at say $186 by option expiry, your gross gain would be $3 and your net gain would be $0.99 or 49%.

The maximum gross gain you can expect to make on this call spread is $4. Suppose the Diamonds are trading at $190 by option expiry. You would have a gain of $7 on the long $183 call position, but a loss of $3 on the short $187 call position, for an overall gain of $4. The net gain in this case—after subtracting the $2.01 net premium paid—is $1.99 or 99%.

The bull call spread can significantly reduce the cost of an option position, but it also caps the potential reward.

Long Bear Put Spread on the DIA

Strategy: Long Bear Put Spread on the DJIA ETF (DIA)

Rationale: Bearish on the Dow Jones, but want to reduce premium paid

Options selected: September $175 Put (long) and September $173 Put (short)

Current Price (bid/ask): $4.40 / $4.65 for $175 Put and $3.85 / $4.10 for $173 Put

Maximum Risk: $0.80 (i.e., option premium paid)

Breakeven: DIA price of $174.20 by option expiry

Maximum Reward: $2 (i.e., the difference between the call strike prices) less net premium paid of $0.80

The bear put spread is a vertical spread strategy that involves initiating a long position on a put option and a simultaneous short position on a put option with the same expiration but a lower strike price. The rationale for using a bear put spread is to initiate a bearish position at a lower cost, in exchange for a lower potential gain. The maximum risk in this example is equal to the net premium paid of $0.80 (i.e., $4.65 premium paid for the long $175 Put and $3.85 premium received for the short $173 Put). The maximum gross gain is equal to the $2 difference in the put strike prices, while the maximum net gain is $1.20 or 150%.

The Bottom Line

Buying options on the Dow Jones is a good alternative to trading the ETF because of the substantially lower capital requirements for trading options, as long as one is familiar with the risks involved.

By Elvis Picardo, Contributor, Investopedia.com

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