The “Dow” is trader lingo for the Dow Jones industrial average, perhaps the most famous stock index in the world. The Dow is an index of 30 stocks issued by large American corporations. Although the Dow isn't very representative of the overall stock universe, investors often watch this index to evaluate action in the stock market. You can take part in the action by trading Dow options.
Standardized options on the Dow Jones industrial average trade on specialized facilities called options exchanges. For example, the Chicago Board Options Exchange lists puts and calls on the Dow. Unlike stock options, index options do not involve the delivery of any underlying securities. Index options are pure cash bets on the direction of prices. If you expect the Dow Jones industrial average to gain value, you buy a call; if you’re pessimistic about prices, you buy a put option. The Chicago Board Options Exchange prices its options based on 1/100 of the current Dow value.
You will need to open a brokerage account with a Level 2 option clearance. Level 2 allows you to buy puts and calls. You can also sell options, but this is a much riskier proposition and requires a higher trading level. When you buy options, the most you can lose is your initial investment, so you know your risks upfront. Before you begin trading options, you might want to form an opinion about future prices.
Taking a Position
You might use technical analysis to decide which options to buy. Technical analysis uses previous price and volume data to predict future prices. You can collect price history on the Dow, as well as other indexes, stocks and economic indicators to help form a forecast. Many technical analysts use charts and equations to guide their trading decisions. You are free to pursue options trading using any system you choose -- dart throwing, chicken entrails, astrology or your mood. These might not be scientific indicators, but they probably have all been used to place bets on options.
You enter your Dow option orders on your broker’s online system. You need to choose an expiration month for your options and a strike price, the reference price to gauge your gain or loss on the index. You can place a market order, which guarantees you immediate purchase of your options at the current price. Or you may specify a limit order, which is the maximum you are willing to pay for your options. Limit orders mean that you won’t overpay, but you have no guarantee your order will be completed.
Closing an Option Position
You can sell your Dow options before the expiration date or hold them until they expire. Your profit or loss depends on the difference between the option’s strike price and the value of the Dow Jones industrial average when your option expires or sells. You close an option position by selling an option identical to the one you bought. The two options offset and cancel each other. Prices of options move quickly, so you might consider having your broker set up sell orders that will be triggered automatically when your option hits your required price.
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.