Index Option

What Is an Index Option?

An index option is a financial derivative that gives the holder the right (however not the obligation) to buy or sell the value of an underlying index, like the S&P 500 index, at the stated exercise price. No real stocks are bought or sold. Frequently, an index option will use a index futures contract as its underlying asset.

Index options are consistently cash-settled and are typically European-style options, meaning they settle just on the date of maturity and have no provision for early exercise.

Figuring out an Index Option

Index call and put options are famous apparatuses used to trade the overall course of an underlying index while putting almost no 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 additionally 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.

Past possibly profiting from general index level developments, index options can be utilized to expand a portfolio when an investor is reluctant to invest straightforwardly in the index's underlying stocks. Index options can likewise be utilized to hedge specific risks in a portfolio. Note that while American-style options can be exercised whenever before expiry, index options will quite often be European-style and can be exercised exclusively on the expiration date.

As opposed to tracking an index straightforwardly, most index options really use an index futures contract as the underlying security. An option on a S&P 500 futures contract, thusly, can be considered a second derivative of the S&P 500 index since the futures are themselves derivatives of the index.

In that capacity, there are more factors 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 decides the overall premium, or price paid. Generally, the multiplier is 100. The S&P 500, notwithstanding, has a 250x multiplier.

Index Option Example

Envision a theoretical index called Index X, which right now has a level of 500. Expect an investor chooses to purchase a call option on Index X with a strike price of 505. On the off chance that this 505 call option is priced at $11, the whole contract costs $1,100 — or $11 x a 100 multiplier.

It is important to note the underlying asset in this contract isn't any individual stock or set of stocks, yet rather the cash level of the index adjusted by the multiplier. In this model, it is $50,000, or 500 x $100. Rather than investing $50,000 in the stocks of the index, an investor can buy the option at $1,100 and use the leftover $48,900 somewhere else.

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 model, that is 516, or 505 plus 11. At any level over 516, this specific trade becomes profitable.

In the event that the index level is 530 at expiration, the owner of this call option would exercise it and receive $2,500 in cash from the opposite side of the trade, or (530 - 505) x $100. Less the initial premium paid, this trade brings about a profit of $1,400.

Features

• 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, yet not the obligation, to either go long (for a call) or short (for a put) the value of the index at a pre-indicated strike price.
• Index options are options contracts that use a benchmark index, or a futures contract in light of that index, as its underlying instrument.