A multi-index option is like setting up a race between two equity indices. Your return is based on the extent one of the indices outperforms the other other.
Think of it like a horse race. You're running Fast Rider against Pounding The Turf in a match race. Except...you don't bet on which horse will win. Instead, you bet on the distance between the horses at the end of the race. The greater the space between them at the finish, the bigger your payment.
You buy a multi-index option pairing the Global Cheese Index (or GCI) with the U.S. Post-Dairy Digestive Relief Medications Index (or PDDRM). The option you buy is based on a 2% spread.
You need one of the options to outperform the other by at least two percentage points in order to exercise it profitably. The GCI rises 5% before the option's expiration. Meanwhile, the PDDRM climbs 9%. The difference between the two indices was four percentage points...well above the 2% needed for your option. You cash in the option for a profit.
However, if the rise in the PDDRM had only been 6%, meaning the spread between the two indices only equaled one percentage point, your option would be worthless. You would have let it expire and eaten the cost of buying the option in the first place.
Related or Semi-related Video
Finance: What Is a Put Option?83 Views
finance a la shmoop what is a put option? hot potato hot potato
ow ow! yeah remember that game well nobody wanted the potato, poor thing. the
players wanted to put it in someone else's hands. well put options kind [glue put around a flaming potato]
of work the same way. a put option is the right or option or choice to sell a
stock or a bond at a given price to someone by a certain end date.
all right example time. you bought netflix stock at the IPO a zillion years
ago at $1 a share. that's you know splits adjusted. all right now it's a hundred
bucks a share. if you sell it you pay taxes on a gain of 99 dollars a share. in
California that would be a tax of something like almost 40 bucks. well the
stock was a hundred but you keep only something like 60. feels totally unfair.
right so you really don't want to sell your stock but you're nervous about the [graph shown]
next few months that Netflix will crater for a while and go down ten
maybe twenty dollars. longer term though you think it'll hit 300. so this is the
perfect setup to maybe look at buying some put options on Netflix. if the stock
goes down your put options go up. with Netflix volatile but at a hundred bucks
a share ,you look up the price of an $80 strike price put option expiring in
December, and you know that's mid-september now .for five bucks a share
you can protect your stock for the next few months .think about it like temporary [stocks placed in vault]
term life insurance. you pay the five dollars a share in the stock goes down
to 82 by mid December, worst of all worlds. well not only did you lose the $5
a share but your stock has lost $18 in value. but had Netflix really cratered
and gone to say $60 a share well you would have exercised your put and sold
your shares at 80 bucks. well those put options you paid $5 for
would be been worth 15 bucks a share. in buying that put option you've [equation shown]
guaranteed that your loss will be no more than a $75 value for your Netflix
position at least for that time period and ignoring taxes. well remember that
options expire after December whatever like the third Friday of the month it's
usually when options expire, you then have no protection and your shares float
along naked. naked? really who knew accounting could get so [paper put option goes "skinny dipping".]
raunchy. yeah well that's naked put options.
that's what they really are people.
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