If you’re looking for information on index options trading, you’ve come to the right place. Index options trading can be a great way to make money, but knowing what you’re doing is important. We can help you learn about index options trading and start making money today.
In India’s option markets the index option is much more common and liquid. The index options also offer options in the same way that stocks are available in stock market options like Nifty, Sensex Bank Nifty etc. What is the index option? Apart from indexing options definitions, see also index options conceptual terms. Tell me the difference between indexing options and indexing methods.
What are index options?
A derivative is a derivative financial contract whose value is derived by a stock exchange. The underlying index will be bought at the specified strike value, but the owner will not be required to do so. Index option comprises call options that give the buyer or seller the right to buy. Index Options are derivative contracts representing an index that collects individual components of stock. Alternatively, the underlying index can be broad-based, like the Dow Jones Industrial Average.
Index Options vs Stock Options
Index options are similar to 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 clearly understand these two options and how they differ from one another.
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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 are index options 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 low-risk derivative instruments 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. Afterwards, investors figure out the number of index options for portfolio hedge.
Example of Index Option
An investor purchases the 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 and the premium, making 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 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 serial, meaning 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
The speculation strategy is used by most of 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.
In 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
The hedging strategy is the most popular correction strategy that supports the traders against risks and difficulties of the trade. With the use of hedging, 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, 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, InvestFw, InvestBy 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.
FAQ
How do you trade index options?
The simplest strategy is to buy a call or to list the indexes. If investors are predicting that index prices would rise they buy call options in advance. Investors can buy a put option to put a bet on stocks dropping in a market. Likewise, a strategy includes buying bull call or bear put spread.
What is the benefit of trading index options?
Index options are used to diversify investment portfolios and get an extensive amount of exposure from (usually) just one trade. The index option reduces a company’s probability of experiencing gap moves and reduces market risk – not individual company risk.
What is index option with example?
Index options are financial instruments which gives the holder an opportunity (but without the obligation) to purchase or sell the value of an index. No real shares can be traded.
Which is better index options or stock options?
Index options were found to be not as volatile as individual stocks options. So, some trades often use an Index Options trading platform to speculate and protect their position against potential losses. Low volatility helps them manage in many circumstances.
