The bottom line is that unless you like to speculate and leverage
your cash, you will want to avoid index futures. However, if you want to
speculate on the direction of the market, I recommend index options,
which are described below and which limit an investor’s loss.
Whether to hold ETFs or low-cost index mutual funds is a very close
decision. If you like to move in and out of the market frequently (which I
do not recommend), ETFs are for you. If you like to invest in the market
on a monthly basis or automatically reinvest your dividends, then no-
load index funds may be the better instrument. However, in recent years
automatic reinvestment of dividends has become possible for stocks and
ETFs if you specify that option to your brokerage firm. This development
further tips the scale in favor of ETFs over index mutual funds.
INDEX OPTIONS
Although ETFs and index futures are very important to investment pro-
fessionals and institutions, the options market has caught the fancy of
many investors. And this is not surprising. The beauty of an option is
embedded in its very name: you have the option, but not the obligation,
to buy or sell stocks or indexes at a given price by a given time. For the
option buyer, this option, in contrast to the futures, automatically limits
your maximum liability to the amount you invested.
There are two major types of options: puts and calls. Callsgive you
the right to buy a stock (or stocks) at a fixed price within a given period
of time. Putsgive you the right to sell a stock. Puts and calls have existed
on individual stocks for decades, but they were not bought and sold
through an organized trading system until the establishment of the
Chicago Board Options Exchange (CBOE) in 1974.
What attracts investors to puts and calls is that liability is strictly
limited. If the market moves against options buyers, they can forfeit the
purchase price, forgoing the option to buy or sell. This contrasts sharply
with futures contracts with which, if the market goes against buyers,
losses can mount quickly. In a volatile market, futures can be extremely
risky, and it could be impossible for investors to exit a contract without
substantial losses.
In 1978, the CBOE began trading options on the popular stock in-
dexes, such as the S&P 500 Index.^11 The CBOE options trade in multiples
264 PART 4 Stock Fluctuations in the Short Run
(^11) In fact, the largest 100 stocks of the S&P 500 Index, called the “S&P 100,” comprise the most pop-
ularly traded index options. Options based on the S&P 500 Index are more widely used by institu-
tional investors.