The S&P 500 Index is a representative sample of 500 American common stock that are listed and traded on the New York, American and NASDAQ Stock Exchanges. It is a benchmark by which common stock price performance can be compared to and provides an indication as to how the American equities markets are performing.

The S&P 500 Index is constructed on the basis of industry groups - Standard & Poor’s identifies important industry categories and then allocates a representative sample of stocks to the group. At present, there are 88 industry groups categorized under four major sectors : industrials, utilities, financial and transportation.

The 500 stocks that comprise the S&P 500 Index represents roughly 80% of the total U.S. equity market capitalization with roughly less than 10% of the total American stock population.

Buying index options offers several advantages :

• Simplicity - All you need is a definite opinion on the stock market’s direction over a certain time frame. There is no need to select individual stocks in an attempt to profit from a market opinion.
• Leverage - All you invest is the option premium, which is substantially smaller than the amount required to purchase shares of stock with a value comparable to the option contract. This leverage can generate profits if the stock index price moves as anticipated.

Buying Call options profiting from a rising market

An investor who anticipates an increase in the price level of the stock market and a corresponding increase in S&P futures contracts may find the purchase of a call option an appropriate strategy.

In September, an investor believes the stock market will continue a major advance, and decides to purchase an at-the-money call option with three months left until maturity. With the December S&P futures at 135.00, the investor purchase an S&P December call 135.00 call at a premium of 3.40, or $1,700. Assume the market does rise immediately and the December S&P futures contract climbs to 140.00. Reflecting an increase in the underlying futures price, the S&P December 135.00 call option rise to 6.80, or $3,400. The investor may sell the call option for 6.80, realizing a profit of 3.40 or $1,700, the difference between the premium paid originally and the current premium. Or the investor may continue to hold option, hoping for an even greater increase in the premium - while recognizing that if the futures prices declines, the profit will decrease and that the time value of the option diminishes as the time of expiration approaches.

Buying Put options profiting from a falling market

Just as an investor who anticipates a rising stock market may purchase calls to profit if his expectation about market direction is correct, an investor who anticipates a falling stock market, purchase puts to realize a profit if his expectations are realized.

In January, an investor believes the stock market will fall, and the decline in the price level will occur over the first quarter of the year. With the March S&P futures prices at 142.00, the investor purchases an S&P March 140.00 put at the premium of 2.00, or $1,000. Over the next three months, the March S&P futures contract declines to 138.00. Reflecting a decrease in the underlying futures price, the put option increases to 4.00, or $2,000. The investor may sell the put option for $2,000, realizing a profit of $1,000, the difference between the premium paid originally and the current premium. Or the investor may hold the put option, hoping for an even greater increase in the premium - while recognizing that if the futures price rises, the profit on the long put position may decrease or be entirely lost, and that the time value of the option diminishes as the time of expiration approaches.

To learn more about investing in index options, ask a Chicago Mercantile Exchange guide to Stock Index Options.