Index Options 2021- What is index options trading and how does it work?

Index Options Trading

What are Index Options?

The financial market offers traders a number of various options to invest their capital and maximise profits. Traders can invest capital in derivatives to minimise the risks and have options of trade other than the primary markets. One such financial derivative is index options. These indices are based on the stock that allows traders to buy and sell the underlying index for a specific time period. 

Investors choose the index options from a pool of stocks of the index to diversify their portfolios and reduce the risk. For example, Dow Jones Industrial Average, S&P500 and Nasdaq Composite etc. are some of the famous stock indices of the trade market. 

Index options are classified as European style rather than the American style due to the exercise. As these are settled in cash when exercised in contrast to options of single stocks, the underlying stock gets transferred when exercised. 

Traders have several options to trade in the indices, and to get into the details of the topic, the article discusses what index option is and how it works to profit traders? So, let’s drive in for more information on index options trading. 

Index Options vs Stock Options

Index options are similar to the stock options as their price increases and decreases because of several factors. It may be the value of underlying security, uncertainty, strike price, expiry time period, dividends, interest rates, etc. However, index options are different from stock options trading. For a trading index, traders should have a clear understanding of these two options and how they differ from one another. 

Underlying Stocks

Stocks and index options are different on the basis of their underlying stocks. The traded stock in stock option is single; it trades on a single company’s stock. At the same time, index options trade on a large basket of stocks from various companies. The index options represent the broad and narrow band of the financial market. In narrowly based indices, the stocks are limited to a certain sector; it may be a financial industry or photonic with few stocks. 

A broad based index option has several financial industries incorporated, which are represented by their components. However, there are not tons of stocks in the broad based index. 

For example, S&P 500 and Dow Jones Industrial averages are broad based index options and S&P 100 and Japan’s index options are good examples of narrow based index options. 

Settlement

The settlement method of both the index options are different, as stock options have an agreement in which the underlying stock is passed from one owner to another, termed as changing hands. On the other hand, index options are settled in cash and the underlying stock is not passed on. 

Moreover, the style of settlement is also contrasting, the stock options prefer the American style exercise, and the index options use the European style exercise. 

In the American style exercise, the underlying stock can be exercised during the period at any point before the expiration date. Whereas the European style exercises the underlying stock by exercising them on the expiry date. So, it is kept until the expiration date. 

Although traders are not compelled to exercise the index options till the expiry date, they can buy and sell the stock and close their trading position at any time. 

Settlement Date

The date of settlement of stock and index options differs; the stock options are settled on the third Friday, with settlement being set on Saturday. Index options are usually traded on Thursday before the third Friday as the last trading day. Index options are determined or settled on Friday. 

The strike price and the settlement price are then compared against the options to check on the change. 

Trading Hours

The trading hours of both the options have some gap between them; the stock option and narrow index option are traded till 04:00 ET, whereas the broad based index options are traded till 04:15 ET. The stock options and narrow based index options are impacted by any news that comes after market closure. In contrast, the broad based index option has a wide range of companies, and there is not much of an impact due to such a reason. 

How do Index Options Trading work?

As of now, we have understood that index options and stock options are different. But to better understand index options trading, we need to get into the depth of its trade. How index options are traded, and how do these work? 

To get answers to the questions, the paragraph talks about index options. Index options trade no actual stocks, but they trade underlying stock indexes. The index options use future index contracts as the underlying assets to trade. In index options, there is no physical trade of the underlying index, so the trade is settled in cash. 

The index options are traded in European style on the expiry date, and traders cannot exercise the asset earlier than their expiration date. A trader purchases the index through an index call option, and with the put option trader gets the right to sell the index option in the financial market. 

These are low risk derivative instruments that provide traders with the advantage of the directional swings of the index. Traders can enjoy unlimited profits through the index call options, with downside loss narrowed to the premium paid on the call options. Whereas the index put options profit is perfect when the index level is minus from the put premium with downside limited to put premium. 

The index options incur a limited loss with more exposure to the stocks at a fraction cost. Index options are generally in multiplier form, determining the contract price, which is usually 100 on most indices and exchanges. 

Investors of the index options can even lock their gains by purchasing put option contracts on each index and lock their sale price on each stock. The strategy works best for small portfolios with protection from market crashes. Although, it does not work in large portfolios and diversification as it is not cost effective to lock positions. 

For diversified portfolios, traders can use hedging strategies for the overall portfolio. Investors determine the correct index used as a proxy for the portfolio. After which, investors figure out the number of index options for portfolio hedge. 

Example of Index Option

An investor purchases index call option of S&P 500 with the following components: 

  • Index spot price: 12000
  • Index call option premium: $50 
  • Contract multiplier: 80 
  • Contract cost: $4000 ($50 x 80)
  • Strike price: 12,500
  • Break Even point: 12,650 (12,500+$50)
  • S&P 500 Index expiry: 13,000

So, the investor would use the call option that exceeds the strike price in addition to the premium, which makes it a profitable undertaking. Traders can determine profit by subtracting contract costs from the gross proceeds. 

Call proceeds: $50,000 {(13000 – 12500) x 100} 

Profit of investor: $46,000 ( $50,000 – $4000) 

Characteristics of Index Options

Index options have some specific characteristics that make them different from all the derivatives. The qualities of the index make index options standalone in the derivatives of the financial market. Investors, by knowing this, can take maximum advantage of the index options in the market. So, here are the characteristics of index options: 

European Style 

The first and most prominent characteristic of index options is their style of trading. In European style, the trade is settled on the expiration and not before that. Thus, traders have to wait till the maturity of the index option contract. The style makes it different from other options contracts that operate on the American style like futures and forward contracts. However, there are always loopholes so that a few index options could be traded in the American style. 

Expiration

Index options expiry date is mostly in a serial manner which means that the index options mature in the months of March, June, September and December. However, there could be changes with some of the index options depending upon the financial instrument traded. Some index options mature every month and could follow the serial manner as well. 

Cash Settlement

Index options are settled in cash and not physically passed forward like other options contracts. These are the European style contracts that are settled in cash without any physical delivery. In these contracts, the cash payment is made after the expiry date of the index options. Thus, investors can have different dates for the settlement of the cash as per their needs. 

Index Options Valuation

Index option valuation includes the following terms: 

  • Strike price
  • Days to expiry 
  • Dividend 
  • The volatility of the stock price 
  • Risk free rate 
  • The underlying index spot price 

All the above mentioned terms are used in the valuation of the index to have depth knowledge of the index options trading. Investors can use them to trade and analyse the market for profitable investments. 

Index Options Trading Strategies

Index options have several strategies that could be used to maximise profits. A trader can plan and analyse the market and the trading instrument to choose the best strategy for the financial market. Below listed are some of the major index options strategies: 

Speculation

Speculation strategy is used by most of the index and stock options traders. They bet on the index of various companies to earn from the increase and decrease of the fluctuations. The strategy requires the study of the market and the index before betting as it bets on future changes, which could result in profit or loss for the trader. 

The bullish strategy of speculation traders buy the call options and bull the call spreads. It looks for a significant increase in the index to earn good profits. Traders go for limited risk to hedge for a short market position. In contrast, the bearish strategy of speculation traders buy the put options and bear the put spreads. In the strategy, traders look for profit from the significant decline of the index traded. 

Income

Income is the premium that traders collect from the mild direction view of the index. In this strategy, the bullish is used where traders sell the bull put spreads. They look for a profit from the rise in the level of the index traded. On the other hand, the bearish strategy of income sells the bear call spreads, where traders look for a decline in the index value. 

Hedging

Hedging strategy is the most popular correction strategy that supports the traders against risks and difficulties of the trade. With the use of hedge, traders can minimise their risks and earn profit. It has catastrophic and comprehensive protection for the portfolio protection of the investors. Catastrophic is cheaper insurance, in which traders buy the put options for protection from the major market decline. 

Comprehensive protection is expensive insurance against portfolio protection. In this, traders buy put options and look for profit from a moderate market decline in the level of the index. 

Benefits of Index Options Trading

Index options have the following important and benefits for the investors of the market: 

  • Used by hedgers and speculators for market exposure with single transactions. 
  • Index option traders have limited loss as per the premium paid for the index with a total potential gain. 
  • Traders of index options enjoy diversification benefits. 
  • Index options are less erratic in comparison to individual stocks that make the index. 
  • Traders have more predictability in index options. 
  • Index options are liquid due to their popularity in the financial market. 
  • Traders of index options can predetermine the risk. 

Conclusion

Traders of index options have a lot of options and benefits with the trade of these derivatives. They can easily invest, monitor and enter and exit the market as per the requirements. However, traders need market understanding and skills for the use of the indices. 

There are several brokers available in the market that offer indices for trading. Investors can go with reputable brokers such as ROInvesting and use the trading tools to invest with indicators and analysis tools. This would benefit the traders with market prediction and high profits. 

Overall, index options trading is a good source of investment that traders can use as a derivative instrument to get good returns with minimum risk involved. 

X

  • Get a Callback

    A trusted broker will contact you today.