Buying Index Call
Market Outlook: Bullish over the short term
Goal: Positioning to profit from an increase in the level of the underlying index.
Assume it is January and you are expecting the market to rise over the next three months. The XJO Index is at 3000. As an alternative to buying a portfolio of shares directly, you decide to buy a March 3000 XJO Index call option for 90 points, or $900.00. That gives you the right, but not the obligation, to "buy" the Index at a level of 3000 at expiry in March. Ignoring your transaction fees and commissions, your break-even point at the end of March is 3000 + 90 = 3090 points.
The most you are risking in this trade is $900, the cost of the option. You have potentially unlimited profits. At the option's expiry in March, for every point that the XJO Index is above your breakeven point of 3090 points, you will make a profit of $10.
Buying Index Put
Market outlook: Bearish over the short term
Goal: Positioning to profit from a decrease in the level of the underlying index
Assume that it is January, and the XJO Index is at 3200. You have a share portfolio worth $64,000 which approximately tracks the index. You believe that there may be a downturn in the market over the next three months.
The March 3200 XJO Index put option has a face value of $32,000, so to protect your $64,000 portfolio you buy two contracts, for 60 points each. The total cost is $1200.
The March 3200 put gives you the right, but not the obligation, to "sell" the Index at a level of 3200 at expiry in March. Ignoring fees and commissions, your break-even point at the end of March is 3200 - 60 = 3140.
By purchasing XJO put options, you can lock in the value of your share portfolio, without having to sell your stocks.