How to buy Dow Jones options

The Dow Jones Industrial Average (DJIA) is an iconic index of 30 American blue chip companies that has existed since the 19th century. The easiest and most cost-effective way to trade the Dow Jones Indices is through an exchange-traded fund (ETF).

The oldest such ETF is the SPDR Dow Jones Industrial Average ETF Trust (DIA). Or “diamond”, it tracks DJIA and tries to track the price and yield performance of the index, each DIA share represents approximately 1/100day The index itself.

If you have limited funds but want to trade the Dow Jones Indices, then DIA ETF options may be a good choice, provided that you also understand the risks involved in options transactions. Read on to learn how to buy and use options to trade the Dow Jones Indices.

Key points

  • The Dow Jones Index is a well-known stock market index that represents 30 influential large American companies.
  • Direct buying and selling of indices is cumbersome and may require considerable capital and complexity.
  • Using ETF options on DIA, you can trade the Dow Jones Indices more easily and economically while keeping risks under control.

Option basics and overview

For the purposes of the following, we will look at a historical example of using DIA options that expired in September 2015. We use this example because the expiration date is less than one month after the “mini flash crash” in August 2015. This is a market event that raised the CBOE Volatility Index (VIX) above 50 for the first time since 2009 ,The pricing of the September 2015 contract has a significant impact.

The focus here will be to buy (or “long”) options, so your risk is limited to the premium paid for the options, not strategies that involve selling (or “shorting”) options. Specifically, we focus on the following options strategies:

  1. Long call
  2. Long bearish
  3. Long call option spread
  4. Long put option spread

Please note that the following example does not consider transaction commissions, which can significantly increase transaction costs.

DIA long call

  • strategy: Long DJIA ETF (DIA)
  • Fundamental: Bullish Underlying Index (DJIA)
  • Option selected: September 2015 184 US dollars call
  • Current premium (buy/sell): 3.75 / 4.00 USD
  • Biggest risk: US$4.00 (i.e. the premium paid)
  • break even: The DIA price is 187 USD when the option expires
  • Potential return: (Current DIA price-breakeven price is $188)
  • Highest reward: Unlimited

If you are optimistic about the Dow Jones Index, you can open a long position (that is, buy) call options.At that time, DIA’s all-time high was $183.35 and reached on May 20, 2015– On the same day, the Dow opened at a high of 18,315.10.

If you think the price will continue to rise, then the next highest execution price will be $184. The strike price of $184 only means that you can buy DIA stock at a price of $184, even if the market price is higher at or before expiration.

If the DIA unit closes below US$184 (equivalent to approximately US$18,400 in the Dow Jones Index) when the option expires, then you will only lose a premium of US$4 for each option you pay for the call option. Your break-even price on this option position is $188 (that is, the strike price is $184 + the premium paid of $4). This means that if the closing price of diamonds on September 18 happens to be $188, the call options will expire at exactly $4, which is the price you paid for them. Therefore, you will get back the $4 premium you paid when you bought the call option, and your only cost will be the commission you paid to open and close the option position.

Beyond the break-even point of $188, the potential profit is theoretically unlimited. If the Dow Jones Index surges to 20,000 points before expiration, the price of the DIA unit will be approximately $200, and your $184 call option will rise to $16, which will bring a substantial profit of $12 or 300% bullish Option earnings.

DIA long

  • strategy: Long Dow ETF (DIA)
  • Fundamental: Bearish underlying index (Dow)
  • Option selected: September 2015 $175 put option
  • Current premium (buy/sell): $4.40 / $4.65
  • Biggest risk: US$4.65 (i.e. the premium paid)
  • break even: The price of DIA at the expiration of the option is $170.35
  • Potential return: (The breakeven price is $170.35-the current price of DIA)
  • Highest reward: $170.35

If you are bearish on the contrary, you can start long bearish positions. In the above example, you will find that the Dow Jones Index fell to at least 17,500 before the option expires, which represents a drop of 4.9% from the initial level of 18,400.

If the DIA unit closes at more than US$175 (equivalent to approximately US$17,500 in the Dow Jones Index) when the option expires, you will only lose the US$4.65 premium paid for the put option.

Your break-even price on this option position is $170.35 (that is, the strike price of $175 minus the premium paid of $4.65). Therefore, if the diamond happens to close at $170.35 when it expires, the call option will be traded at your purchase price of $4.65. If you sell them at that price, you will break even, and the only cost incurred is the commission paid for opening and closing option positions.

Below the break-even point of $170.35, the theoretical potential profit is as high as $170.35. This occurs when the price of diamonds is almost impossible to fall all the way to $0 (this will require the DJIA index to also trade at zero!). If the diamond is traded at any level below $170.35 at maturity, your bearish position can still make money, which corresponds to an index level of approximately 17,035.

Suppose the Dow Jones Index plummets to 16,500 points when it expires. The trading price of Diamonds is US$165, and the price of a US$175 put option is about US$10, and the potential profit is US$5.35 or your put option’s return is 115%.

DIA long call option spread

  • strategy: Dow Jones Index ETF (DIA) long call option spread
  • Fundamental: Optimistic about the Dow Jones index, but hope to reduce the premium paid
  • Selected option: September 184 USD call options (long position) and September 188 USD call options (short position)
  • Current premium (buy/sell): 3.75 USD/4.00 USD (184 USD) and 1.99 USD/2.18 USD (188 USD)
  • Biggest risk: $2.01 (i.e. the net premium paid)
  • break even: The price of DIA when the option expires is US$186.01
  • Highest reward: US$4 (the difference between the call option strike price) minus the net premium paid of US$2.01

Bull market call option spread is a vertical spread strategy that involves establishing a long position on a call option and simultaneously establishing a short position on the call option. The expiration date is the same but the strike price is higher. The goal of this strategy is to take advantage of a bullish view of the underlying securities, but at a lower cost than direct long bullish positions. This is achieved through the premium received on short bullish positions.

In this example, the net premium paid is $2.01 (that is, the $4 premium paid for the long call position of $184 minus the $1.99 premium received for the short call position). Note that you pay the asking price when you buy or go long options, and you receive the bid price when you sell or short options.

In this example, your break-even price is $186.01 (that is, the strike price of the long call option is $184 + the net premium paid is $2.01). If the diamond’s trading price at the expiration of the option is $187, your total profit will be $3, and your net profit will be $0.99 or 49%.

You can expect the maximum total return on this call option spread to be $4. Assume that the transaction price of the diamond at the expiration of the option is $190. You will make a profit of $6 on the $184 call option long position, but you will lose $2 on the $188 short position in the call option, resulting in an overall gain of $4. In this case, the net income after deducting the $2.01 net premium paid is $1.99 or 99%.

A call option spread can significantly reduce the cost of an option position, but it also limits the potential return.

DIA long put option spread

  • strategy: Dow Jones Index ETF (DIA) long put option spread
  • Fundamental: Bearish on the Dow Jones index, but hope to reduce the premium paid
  • Selected option: September $175 puts (long) and September $173 puts (short)
  • Current premium (buy/sell): US$4.40/US$4.65, US$175 put option and US$3.85/4.10 US$, US$173 put option
  • Biggest risk: 0.80 USD (the premium paid)
  • break even: The price of DIA at the expiration of the option is $174.20
  • Highest reward: US$2 (the difference between the call option strike price) minus the net premium paid of US$0.80

A bear market put spread is a vertical spread strategy that involves establishing a long position on a put option and simultaneously doing a short position on the put option with the same expiration date but a lower strike price. The basic principle of using a bear market put option spread is to start a bearish position at a lower cost in exchange for a lower potential return. The maximum risk in this example is equal to the net premium paid of $0.80 (that is, the long premium paid for the $175 put option is $4.65 minus the $3.85 premium charged for the $173 put option). The maximum total return is equal to the $2 difference in the strike price of the put option, and the maximum net return is $1.20 or 150%.

Bottom line

Buying ETF options on DIA is a wise way to trade Dow Jones Indices, and may be a good alternative to trading ETF itself, because when trading options, as long as you are familiar with risks, capital requirements and strategic flexibility will be greatly reduced Involved.

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