Index Options

 

Definition of Index Options

The term “index options” (IO) refers to the financial derivatives that give the derivative holder the right to purchase or sell the value of the underlying index at a pre-decided strike price. The transaction is purely based on the value of the index, and it doesn’t involve the purchase or sale of any actual stocks. (IO) are settled in cash; most are European-style options, i.e. they can only be settled on their expiry date.

Explanation

The investors who transact in index options have the right to purchase or sell the underlying stock market index for a particular period. (IO) are one of the best investment tools for portfolio diversification as they are constructed based on a large basket of stocks that constitute the underlying index.

How Does Index Options Work?

In the case of the most basic options trading, i.e. call and put options, (IO) limits the risk of loss to the level of the premium paid for it. On the other hand, the profit potential for index put options is capped at the index level minus the premium paid, while that of the index call options is unlimited. Further, (IO) is also used to earn profits from movements in the index level, diversify investment portfolios without directly investing in the underlying stocks, and hedge portfolio risks.

Example

Let us take the example of a hypothetical index that is currently trading at 1,000. Let us also assume that an investor purchased an index call option with a strike price of 1,010. The contract has a multiplier of 100 that determines its overall price. Now the index call option is priced at $15, so the entire contract price is $1,500 (= $15 x 100).

In this transaction, the downside risk is limited to the premium paid, i.e. $1,500, while the breakeven point of the index call option is its strike price plus the premium paid, i.e. 1,025 (= 1,010 + 15). Hence, the trade will be profitable at any level above 1,025, and the upside is unlimited.

Types of Index Options

Primarily, the (IO) vary on the basis of the underlying index, such as DAX 30, Nikkei 225, S&P 500, etc., in which the investor gains the right to purchase or sell a certain number of units at a pre-determined price. (IO) may also be differentiated on the basis of the specific sector on which they focus, e.g. industries like healthcare, banking, IT, etc.

Index Options List

The list provided below captures the symbol, description, and country of some of the most commonly traded (IO).

Symbol	Index description	Country
DAX	DAX 30	Germany
HSI	Hang Seng	Hong Kong
N225	Nikkei 225	Japan
KOSPI	KOSPI 200	Korea
FTSE	FTSE 100	UK
SPX	S&P 500	USA
NDX	NASDAQ 100	USA
OEX	S&P 100	USA

Index Options Strategies

The investors of (IO) can use some of the following strategies:

• Buy index call or put options: The investors can buy index call options to earn a profit if they expect the market to go up or buy index put options opposite if they expect it to go down.
• Buy bull call spreads or bear put spreads: It allows investors to earn limited profit in exchange for lower capital investment. Bull call spreads are bought if the index is expected to move up, while bear put spreads are bought if a downward trend is expected.
• Sell covered calls: Investors purchase the underlying stocks for the index and sell index call options. They can either earn profit from the call options premium if the index goes down or from the underlying stocks if the index goes up.

Index Options Symbols

The symbols mentioned below are statistical values that investors use to overview the index (IO).

• Δ (Delta): It measures the relationship between the option price and the underlying index.
• γ (Gamma): It measures the sensitivity of delta per unit change in the underlying index.
• λ (Lambda): It measures the % change in the value of the option for a 1% change in the underlying index value.
• ρ (Rho): It measures the % change in the value of the option for a 1% change in the interest rate.
• θ (Theta): It measures the sensitivity of the value of the option value for a unit change (7 days) in time.
• κ (Kappa): It measures the % change in the value of the option for a 1% change in its volatility.

Advantages

• (IO) are one of the best diversification alternatives available to investors as they are constructed on the basis of a large basket of stocks.
• Predicting the value of index options is easier as they are invariably less volatile.
• The bid-ask spread of (IO) is rational, and the prices are close to their fair value most of the time as they are usually traded in high volumes, given their popularity among the traders.
• The settlement of (IO) is much easier as they are settled in cash as compared to the delivery of stocks in the case of other options.
• Purchase of index options involves relatively lower investment as compared to the purchase of individual stock options.

Disadvantages

• Index options trading offers limited upside; hence, it does not attract investors seeking higher returns in exchange for higher risks.
• The pricing model used for (IO) is very complicated.

Conclusion

So, it can be seen that investors use index options for various investment purposes, such as hedging portfolio risk, speculating future index movement, etc. Investors implement different strategies that minimize the risk to a large extent, but it comes in exchange for limited returns.

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