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 S&P 500 index, at the stated exercise price. No actual stocks are bought or sold. Often, an index option will utilize an index futures contract as its underlying asset.
Index options are always cash-settled and are typically European-style options, meaning they settle only on the date of maturity and have no provision for early exercise.
Key Takeaways
Index options are options contracts that utilize a benchmark index, or a futures contract based on that index, as its underlying instrument.
Index options are typically European style and settle in cash for the value of the index at expiration.
Like all options, index options will give the buyer the right, but not the obligation, to either go long (for a call) or short (for a put) the value of the index at a pre-specified strike price.
Understanding Index Options
Index call and put options are popular tools used to trade the general direction of an underlying index while putting very little capital at risk. The profit potential for index call options is unlimited, while the risk is limited to the premium paid for the option.
For index put options, the risk is also limited to the premium paid, while 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 to hedge specific risks in a portfolio.
S&P 500 and VIX
The busiest index options in the U.S. market are options on SPXW (representing the S&P 500) and VIX, the Cboe Volatility Index.
Note that while American-style options can be exercised at any time before expiry, index options tend to be European-style and can be exercised only on the expiration date.
Rather than tracking an index directly, most index options actually utilize an index futures contract as the underlying security. Anoptionon an S&P 500 futures contract, therefore, can be thought of as a second derivative of the S&P 500 index since the futures are themselves derivatives of the index.
As such, there are more variables to consider as both the option and the futures contract have expiration dates and their own risk/reward profiles. With such index options, the contract has a multiplier that determines the overall premium, or price paid. Usually, the multiplier is 100. The S&P 500, however, has a 250x multiplier.
Example of an Index Option
Imagine a hypothetical index called Index X, which currently has a level of 500. Assume an investor decides to purchase a call option on Index X with a strike price of 505. If this 505 call option is priced at $11, the entire contract costs $1,100—or $11 x a 100 multiplier.
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 is 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 Are Index Options Strategies?
Common index options strategies include (1) long call/long put, (2) covered call/protective put, (3) straddle, and (4) strangle.
How Are Index Options Taxed?
Because traders are unlikely to hold options for more than a year, these instruments are taxed as short-term capital gains. However, broad-based index options are taxed according to the 60/40 rule: 60% of the gains are treated as long-term gains, and 40% as short-term gains, regardless of the holding period. These tax advantages give broad-based index options an advantage over other options instruments.
What Are You Actually Buying When You Trade Index Options?
When you trade an index option, you are actually buying the right to buy or sell a futures contract on the underlying index. Since these futures are themselves derivatives, an index option can be considered a second derivative of the underlying index.
The Bottom Line
Index options give traders the ability to hedge their portfolios with exposure to a broad cross-section of the market. As with other options, it is important to understand how expiration dates and strike prices affect their value. Unlike some other options, index options are usually cash-settled and cannot be redeemed before their expiration date.
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.
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 S&P 500 index, at the stated exercise price. No actual stocks are bought or sold.
An indexed contract is very common in commodity markets, especially gas markets. It is also referred to as floating or variable price contract. It means that the price paid for the commodity depends on the evolution of market prices, spot or forward.
A call option signifies a bullish view and a put option represents a bearish view. Index options can also be grouped as In-the-Money (ITM), Out-the-Money (OTM), and At-the-Money (ATM). Among the three, only ITM options are considered to give gains if exercised.
An investor buys a call option on the S&P 500 index with a strike price of 4,020, which is 0.5% higher than the current trading price of 4,000. The contract has a multiplier of 100, so if the option is priced at $10, the investor would need to pay $1,000.
The S&P 500 is considered one of the best gauges of large U.S. stocks and even the entire equities market because of its depth and diversity. You can't invest directly in the S&P 500 because it's an index but you can invest in one of the many funds that use it as a benchmark and track its composition and performance.
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 S&P 500 index, at the stated exercise price. No actual stocks are bought or sold.
An index futures contract works just like a regular futures contract. It is a legally binding agreement between a buyer and a seller that allows traders to buy or sell a contract on a financial index and settle it at a future date.
Index Options are found to be less volatile than single Stock Options. This is why many traders, often choose Index Options to speculate as well as hedge their positions. Lower volatility makes them easier to manage in most cases.
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.
The most actively traded index options in India are based on the Nifty 50 and Sensex indexes. Options are also available on other indexes like Nifty Bank, Fin Nifty, Nifty IT, Nifty Metal etc. You can do index option trading based on the following options available in the Indian stock market.
The difference in face value between SPX and SPY options is one of the key differences for investors with small capital. If you take contracts with the same parameters (same strike price, expiration date, etc.), buying an SPY option will be about 10 times cheaper than the SPX options.
Investors who use options to manage risk look for ways to limit potential loss. They may choose to purchase options, since loss is limited to the price paid for the premium. In return, they gain the right to buy or sell the underlying security at an acceptable price.
The demand for call options can increase the price of the options contract, and this can lead to an increase in the demand for the underlying stock. Moreover, when investors buy call options, they effectively create a new source of buying pressure for the stock.
A benchmark is often a market index, or combination of indexes that investors and portfolio managers use to measure an investment portfolio's performance. An index tracks the performance of a broad asset class, such as stocks of companies listed on stock exchanges.
A benchmark index is a standard against which the performance of a security, investment strategy, or investment manager can be measured. It is therefore important to select a benchmark that has a similar risk-return profile of the security, strategy, or manager in question.
ETFs: ETFs are passive schemes tracking benchmark indices such as Nifty and Sensex. ETFs don't have an aim to beat the benchmark index they are tracking and have an aim to give benchmark returns.
In statistics relating to national economies, the indexation of contracts also called "index linking" and "contract escalation" is a procedure when a contract includes a periodic adjustment to the prices paid for the contract provisions based on the level of a nominated price index.
Index-based insurance is coverage under which an entity assuming risk (the "insurer") agrees to pay the indemnitee (the "insured") an agreed amount upon the occurrence of a specified event, such as an earthquake or hurricane of specified intensity.
IBP establishes baseline rates and ties periodic rate adjustments to an objective, third-party pricing index. Some common pricing methods include: dedicated contract, annual contract, quarterly contract, and spot market bids.
Let's say you decide to speculate on the S&P 500. The E-mini S&P 500 futures are priced at $50 multiplied by the index value. So, you might buy a futures contract when it's trading at 5,000 points, resulting in a contract value of $250,000 ($50 x 5,000).
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