How To Buy Options On the Dow Jones

The Dow Jones Industrial Average (DJIA) is a hallmark index of 30 American blue-chip companies, which has been around since the 19th century. The easiest and most cost-effective avenue to trade the Dow Jones is through an exchange-traded fund (ETF).

The oldest such ETF is the SPDR Dow Jones Industrial Average ETF Trust (DIA) or "Diamonds," which tracks the DJIA and seeks to track the price and yield performance of the index, with each DIA share representing approximately 1/100^th of the index itself.

If you have limited capital but want to trade the Dow, DIA ETF options might be a good way to go, assuming you also understand the risks of options trading.

Options Basics & Overview

For the purposes of what follows, we will look at historical examples using DIA options that expired back in September 2015. We take this example because that expiration date came less than one month after the August 2015 "mini flash crash", a market event that lifted the CBOE Market Volatility Index (VIX) above 50 for the first time since 2009, greatly influencing pricing on the September 2015 contracts.  

The emphasis here will be on buying (or going “long”) options, so that your risk is limited to the premium paid for the options, rather than strategies that involve writing (or going “short”) options. Specifically, we focus on the following option strategies:

1. Long Call
2. Long Put
3. Long Bull Call Spread
4. Long Bear Put Spread

DIA Long Call

• Strategy: Long Call on the DJIA ETF (DIA)
• Rationale: Bullish on the underlying index (DJIA)
• Option selected: September '15 $184 Call
• Current Premium (bid/ask): 3.75 / $4.00
• Maximum Risk: $4.00 (i.e., option premium paid)
• Break-even: DIA price of $187 by option expiry
• Potential Reward: (Prevailing DIA price—break-even price of $188)
• Maximum Reward: Unlimited

If you are bullish on the Dow, you could initiate a long position (i.e. buy) a call option. The all-time high on the DIA back then was $183.35, which was reached on May 20, 2015—the same day that the DJIA index opened at a peak of 18,315.10.

If you thought the price would continue to rise, the next highest strike price would be $184. A strike price of $184 simply means that you could buy DIA shares at $184, even if the market price were higher at or before expiration.

If the DIA units closed below $184—which corresponds to a Dow Jones level of about 18,400—by option expiry, you would have only lost the premium of $4 per option that you paid for the calls. Your break-even price on this option position is $188 (i.e., the strike price of $184 + $4 premium paid). What this means is that if the Diamonds closed exactly at $188 on September 18, the calls would expire at exactly $4, which is the price that you paid for them. Thus, you would recoup the $4 premium paid when you bought the calls, and your only cost would be the commissions paid to open and close the option position.

Beyond the break-even point of $188, the potential profit is theoretically unlimited. If the Dow soared to 20,000 before expiration, the DIA units would go for about $200, and your $184 call would rise to $16, a tidy $12 profit or 300% gain on your call position.

DIA Long Put

• Strategy: Long Put on the DJIA ETF (DIA)
• Rationale: Bearish on the underlying index (the DJIA)
• Option selected: September'15 $175 Put
• Current Premium (bid/ask): $4.40 / $4.65
• Maximum Risk: $4.65 (i.e., option premium paid)
• Break-even: DIA price of $170.35 by option expiry
• Potential Reward: (Break-even price of $170.35—Prevailing DIA price)
• Maximum Reward: $170.35

If you were instead bearish, you could initiate a long put position. In the example described above, you would be looking for the Dow to decline to at least 17,500 by option expiry, representing a 4.9% drop from the beginning level of 18,400.

If the DIA units closed above $175—which corresponds to a Dow Jones level of about 17,500—by option expiry, you only would have lost the premium of $4.65 that you paid for the puts.

Your break-even price on this options position is $170.35 (i.e., the strike price of $175 less $4.65 premium paid). Thus, if the Diamonds closed exactly at $170.35 at expiration, the calls would trade at your purchase price of $4.65. If you sold them at that price, you would break even, with the only cost incurred being the commissions paid to open and close the option position.

Below the break-even point of $170.35, the potential profit is theoretically a maximum of $170.35, which would happen in the nearly impossible event of the Diamonds dropping all the way to $0 (which would require the DJIA index to also be trading at zero!). Your put position would still make money if the Diamonds are trading at any level below $170.35 at expiration, which corresponds to an index level of about 17,035.

Let’s say the Dow Jones plunged to 16,500 by expiration. The Diamonds would be trading at $165, and the $175 puts would be priced around $10, for a potential $5.35 profit or 115% gain on your put position.

DIA Long Bull Call Spread

• Strategy: Long Bull Call Spread on the DJIA ETF (DIA)
• Rationale: Bullish on the Dow Jones, but want to reduce premium paid
• Options selected: September $184 Call (long) and September $188 Call (short)
• Current Premium (bid/ask): 3.75 / $4.00 for $184 Call and $1.99 / $2.18 for $188 Call
• Maximum Risk: $2.01 (i.e., net option premium paid)
• Break-even: DIA price of $186.01 by option expiry
• Maximum Reward: $4 (i.e., the difference between the call strike prices) less net premium paid of $2.01

The bull call spread is a vertical spread strategy that involves initiating a long position on a call option and a simultaneous short position on a call option with the same expiration but at a higher strike price. The objective of this strategy is to capitalize on a bullish view on the underlying security, but at a lower cost than an outright long call position. This is achieved through the premium received on the short call position.

In this example, the net premium paid is $2.01 (i.e., premium paid of $4 for the $184 long call position less the premium received of $1.99 on the short call position). Note that you pay the ask price when you buy or go long on an option, and receive the bid price when you sell or go short on an option.

Your break-even price in this example is $186.01 (i.e., the strike price of $184 on the long call + $2.01 in net premium paid). If the Diamonds are trading at say $187 by option expiry, your gross gain would be $3, and your net gain would be $0.99 or 49%.

The maximum gross gain you can expect to make on this call spread is $4. Suppose the Diamonds are trading at $190 by option expiry. You would have a gain of $6 on the long $184 call position, but a loss of $2 on the short $188 call position, for an overall gain of $4. The net gain in this case, after subtracting the $2.01 net premium paid, is $1.99 or 99%.

The bull call spread can significantly reduce the cost of an option position, but it also caps the potential reward.

DIA Long Bear Put Spread

• Strategy: Long Bear Put Spread on the DJIA ETF (DIA)
• Rationale: Bearish on the Dow Jones, but want to reduce premium paid
• Options selected: September $175 Put (long) and September $173 Put (short)
• Current Premium (bid/ask): $4.40 / $4.65 for $175 Put and $3.85 / $4.10 for $173 Put
• Maximum Risk: $0.80 (i.e., option premium paid)
• Break-even: DIA price of $174.20 by option expiry
• Maximum Reward: $2 (i.e., the difference between the call strike prices) less net premium paid of $0.80

The bear put spread is a vertical spread strategy that involves initiating a long position on a put option and a simultaneous short position on a put option with the same expiration but a lower strike price. The rationale for using a bear put spread is to initiate a bearish position at a lower cost, in exchange for a lower potential gain. The maximum risk in this example is equal to the net premium paid of $0.80 (i.e., $4.65 premium paid for the long $175 Put minus $3.85 premium received for the short $173 Put). The maximum gross gain is equal to the $2 difference in the put strike prices, while the maximum net gain is $1.20 or 150%.

The Bottom Line

Buying ETF options on the DIA is a smart way to trade the Dow Jones and may be a good alternative to trading the ETF itself because of the substantially lower capital requirements and strategy flexibility afforded when trading options, as long as one is familiar with the risks involved.