of $100 per point of index value—cheaper than the $250-per-point mul-
tiple on the popular S&P 500 Index futures.
An index allows investors to buy the stock index at a set price
within a given period of time. Assume that the S&P 500 Index is now
selling for 1,400, but you believe that the market is going to rise. Let us
assume you can purchase a call option at 1,450 for three months for 30
points, or $3,000. The purchase price of the option is called the premium,
and the price at which the option has value when it expires—in this case
1,450—is called the strike price. At any time within the next three months
you can, if you choose, exercise your option and receive $100 for every
point that the S&P 500 Index is above 1,450.
You need not exercise your option to make a profit. There is an ex-
tremely active market for options, and you can always sell them before
expiration to other investors. In this example, the S&P 500 Index will
have to rise above 1,480 for you to show a profit if you hold until the ex-
piration, since you paid $3,000 for the option. But the beauty of options
is that, if you guessed wrong and the market falls, the most you can lose
is the $3,000 premium you paid.
An index put works exactly the same way as a call, but in this case
the buyer makes money if the market goes down. Assume you buy a put
on the S&P 500 Index at 1,350, paying a $3,000 premium. Every point the
S&P 500 Index is below 1,350 at expiration will recoup $100 of your ini-
tial premium. If the index falls to 1,320 by expiration, you have broken
even. Every point below 1,320 gives you a profit on your option.
The price that you pay for an index option is determined by the mar-
ket and depends on many factors, including interest rates and dividend
yields. But the most important factor is the expected volatility of the mar-
ket itself. Clearly, the more volatile the market, the more expensive it is to
buy either puts or calls. In a dull market, it is unlikely that the market will
move sufficiently high (in the case of a call) or low (in the case of a put) to
give options buyers a profit. If this low volatility is expected to continue,
the prices of options are low. In contrast, in volatile markets, the premi-
ums on puts and calls are bid up as traders consider it more likely that the
options will have value by the time of their expiration.^12
The price of options depends on the judgments of traders as to the
likelihood that the market will move sufficiently to make the rights to
buy or sell stock at a fixed price valuable. But the theory of options pric-
ing was given a big boost in the 1970s when two academic economists,
Fischer Black and Myron Scholes, developed the first mathematical for-CHAPTER 15 The Rise of Exchange-Traded Funds, Stock Index Futures, and Options 265
(^12) Chapter 16 will discuss a valuable index of option volatility called VIX.