In the financial markets, an index is a hypothetical portfolio of financial instruments that represent a specific market or market segment. Examples of stock market indices are the S&P 500, Dow Jones Industrial Average, FTSE 100, NASDAQ-100, Nikkei 225, and Russell 2000.
An option refers to a type of derivative that derives value from another asset, called the underlying asset, and it’s a contract that gives the option holder the right to buy purchase or sell the underlying instrument at a specified time in the future.
Combining the two definitions, an index option is a derivative that confers to the index option holder the right to buy or sell an index’s value at a certain exercise price. The contract also specifies when the option can or should be exercised.
Properties of index options
Cash settled: Index options are settled in cash. The option holder doesn’t buy or sell any stocks, as opposed to investing in individual securities’ options where physical delivery of the traded security is actually done.
Rights conferred: As an index option holder, you are entitled to demand a cash value equivalent to the value of the underlying index. You are not given the right or obligation to purchase or sell individual stocks that make up the index.
Index options are typically European-style: You can only exercise the option upon expiration. However, there are a few American-style index options. These can be exercised at any date before the expiration/maturity date.
Quick settlement: Normally, settlement is done on the day following the exercise date. The settlement price is determined differently depending on the index. An index option trader needs to refer to the option’s contract specifications to know exactly how pricing will be done.
How index option trading works
The basic idea of index trading is betting on fluctuations in the value of the index. When buying an index option, you pay a premium. The premium amount is the cost of holding the right to demand underlying index’s cash value at any time allowed by the contract.
Investors use call options and put options to benefit from these fluctuations, whether the index’s level goes up or down. A call index option is used to make a bet on the index’s level going up or down. The potential profit of an index call option is unlimited, while its risk is limited to the premium paid for the option.
A put index option is ideal when the level of the index is expected to go down. Potential profit can only go as high as the index’s level minus the premium paid, while its risk is limited to the premium paid.
Advantages of index options trading
In addition to benefiting from general movements in the level of the index, index options provide several other benefits as discussed below.
When you invest in index-based options rather than those based on individual stocks, you are able to diversify your portfolio better. An index option allows you to gain exposure to an entire market or market segment through one transaction. If you were to obtain the same level of diversification using individual stock options, you’d be required to make quite a big number of transactions and thus incur higher costs.
2. Index options are less volatile and thus more predictable
Predictability of investment instruments in a crucial aspect of risk in investments. Since an index tends to average wild ups and downs of the individual instruments that make it, options based on indices show less volatility than individual stocks.The increased predictability of indices makes it easier to make profitable decisions when buying index options.
3. More liquidity
Index options are very popular among investment firms, hedge funds, and individual traders. At any given time, there are high volumes of options to trade. This reduces the spreads traders quote in the market and increases the liquidity of these financial derivatives. If liquidity is a top priority in your investment objectives, index options could be the right instruments to add to your portfolio.
There is a huge number of index options on the international financial markets. While this is a good thing, investors may be faced with the challenge of choosing the most suitable option for their investment needs. Some index options have unique advantages over others, for example, tax advantages.
Knowing the specific characteristics of an index option that you are considering can help you to make the right investment decision. Therefore, do some research or consult an investment adviser before venturing into stock index trading.