Individual stocks can be quite volatile. For example, if there is major unforeseen news in one particular company, it might well rock the stock for a few days. On the other hand, even serious turmoil in a major company that's part of the S&P 500 probably wouldn't cause that index to fluctuate very much.
What's the moral of the story? Trading options that are based on indices can partially shield you from the huge moves that single news items can create for individual stocks. Consider neutral trades on big indices, and you can minimize the uncertain impact of market news.
How can you trade more informed?
Consider trading strategies that will be profitable if the market stays still, such as short spreads (also called credit spreads) on indices. Sudden stock moves based on news tend to be quick and dramatic, and often the stock will then trade at a new plateau for a while. Index moves are different: less dramatic and less likely impacted by a single development in the media.
Like a long spread, a short spread is also made up of two positions with different strike prices. But in this case the more expensive option is sold and the cheaper option is bought. Again, both legs have the same underlying security, same expiration date, same number of contracts and both are either both puts or both calls. The effects of time decay are somewhat reduced since one option is bought while the other is sold.
A key difference between long spreads and short spreads is short spreads are traditionally constructed to not only be profitable relative to direction, but even when the underlying remains the same. So short call spreads are neutral to bearish and short put spreads are neutral to bullish.
An example of a put credit spread used with an index would be to sell the 100-strike put and buy the 95-strike put when the index is around 110. If the index remains the same or increases, both options would remain out-of-the-money (OTM) and expire worthless. This would result in the maximum profit for the trade, limited to the credit remaining after selling and buying each strike. In this case, let's estimate that credit to be $2 per contract. The maximum potential loss is also limited; it's the difference between the strikes less the credit received for the spread. So the potential risk nets out to $3 per contract (100 — 95 — $2).
Lastly, remember spreads involve more than one option trade, and therefore incur more than one commission. Bear this in mind when making your trading decisions.