Index Option Trading Explained

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Index Option Trading

Introduced in 1981, stock index options are options whose underlying is not a single stock but an index comprising many stocks. Investors and speculators trade index options to gain exposure to the entire market or specific segments of the market with a single trading decision and often thru one transaction. Obtaining the same level of diversification using individual stocks or individual stock options require numerous transactions and consequently slower decision making and higher costs.

Leverage & Predetermined Risk for the Buyer

Like equity options, trading index options gives the investor leverage and predetermined risk. The index option buyer gains leverage as the premium paid relative to the contract value is small. Consequently, for a small percentage moves of the underlying index, the index option holder can see large percentage gains for his position. Furthermore, risk is predetermined as the most the index option trader can lose is the premium paid to hold the options.

Contract Multiplier

Stock index options typically have a contract multiplier of $100. The contract multiplier is used to compute the cash value of each index option contract.

Premium

Similar to equity options, index options premiums are quoted in dollars and cents. The price of a single equity index option contract can be determined by multiplying the quoted premium amount by the contract multiplier. This is the amount that an index option buyer will need to pay to purchase the option and the amount that the index option writer will receive when selling the option.

Rights Conferred

As index options are cash-settled options, the holder of an index option does not possess the right to purchase or sell the underlying stocks of the index but rather, he or she is entitled to demand the equivalent cash value from the option writer upon exercising his option.

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Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

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Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

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Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Index Option

What is an Index Option?

An index option is a financial derivative that gives the holder the right, but not the obligation, to buy or sell the value of an underlying index, such as the Standard and Poor’s (S&P) 500, at the stated exercise price on or before the expiration date of the option. No actual stocks are bought or sold; index options are always cash-settled, and are typically European-style options.

Basics of an Index Option

Index call and put options are simple and popular tools used by investors, traders and speculators to profit on the general direction of an underlying index while putting very little capital at risk. The profit potential for long index call options is unlimited, while the risk is limited to the premium amount paid for the option, regardless of the index level at expiration. For long index put options, the risk is also limited to the premium paid, and the potential profit is capped at the index level, less the premium paid, as the index can never go below zero.

Beyond potentially profiting from general index level movements, index options can be used to diversify a portfolio when an investor is unwilling to invest directly in the index’s underlying stocks. Index options can also be used in multiple ways to hedge specific risks in a portfolio. American-style index options can be exercised at any time before the expiration date, while European-style index options can only be exercised on the expiration date.

Key Takeaways

  • Index options are options to buy or sell the value of an underlying index.
  • Index options have downside that is limited to the amount of premium paid and upside that is unlimited.

Index Option Examples

Imagine a hypothetical index called Index X, which has a level of 500. Assume an investor decides to purchase a call option on Index X with a strike price of 505. With index options, the contract has a multiplier that determines the overall price. Usually the multiplier is 100. If, for example, this 505 call option is priced at $11, the entire contract costs $1,100, or $11 x 100.

It is important to note the underlying asset in this contract is not any individual stock or set of stocks but rather the cash level of the index adjusted by the multiplier. In this example, it is $50,000, or 500 x $100. Instead of investing $50,000 in the stocks of the index, an investor can buy the option at $1,100 and utilize the remaining $48,900 elsewhere.

The risk associated with this trade is limited to $1,100. The break-even point of an index call option trade is the strike price plus the premium paid. In this example, that is 516, or 505 plus 11. At any level above 516, this particular trade becomes profitable. If the index level was 530 at expiration, the owner of this call option would exercise it and receive $2,500 in cash from the other side of the trade, or (530 – 505) x $100. Less the initial premium paid, this trade results in a profit of $1,400.

What is index option trading and how does it work?

Index options are financial derivatives based on stock indices such as the S&P 500 or the Dow Jones Industrial Average. Index options give the investor the right to buy or sell the underlying stock index for a defined time period. Since index options are based on a large basket of stocks in the index, investors can easily diversify their portfolios by trading them. Index options are cash settled when exercised, as opposed to options on single stocks where the underlying stock is transferred when exercised.

Index options are classified as European-styled rather than American for their exercise. European-styled options may only be exercised upon expiration, while American options can be exercised at any time up until expiration. Index options are flexible derivatives and can be used for hedging a stock portfolio consisting of different individual stocks or for speculating on the future direction of the index.

Investors can use numerous strategies with index options. The easiest strategies involve buying a call or put on the index. To make a bet on the level of the index going up, an investor buys a call option outright. To make the opposite bet on the index going down, an investor buys the put option. Related strategies involve buying bull call spreads and bear put spreads. A bull call spread involves buying a call option at a lower strike price, and then selling a call option at a higher price. The bear put spread is the exact opposite. By selling an option further out of the money, an investor spends less on the option premium for the position. These strategies allow investors to realize a limited profit if the index moves up or down but risk less capital due to the sold option.

Investors may buy put options to hedge their portfolios as a form of insurance. A portfolio of individual stocks is likely highly correlated with the stock index it is part of, meaning if stock prices decline, the larger index likely declines. Instead of buying put options for each individual stock, which requires significant transaction costs and premium, investors may buy put options on the stock index. This can limit portfolio loss, as the put option positions gain value if the stock index declines. The investor still retains upside profit potential for the portfolio, although the potential profit is decreased by the premium and costs for the put options.

Another popular strategy for index options is selling covered calls. Investors may buy the underlying contract for the stock index, and then sell call options against the contracts to generate income. For an investor with a neutral or bearish view of the underlying index, selling a call option can realize profit if the index chops sideways or goes down. If the index continues up, the investor profits from owning the index but loses money on the lost premium from the sold call. This is a more advanced strategy, as the investor needs to understand the position delta between the sold option and the underlying contract to fully ascertain the amount of risk involved.

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