Updated July 11, 2023
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. Cash settlements are made for (IO); most of these options are European-style, meaning they can only be settled on their expiry date.
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, investors cap the profit potential for index put options at the index level minus the premium paid. At the same time, they enjoy unlimited profit potential with index call options. Moreover, investors also utilize (IO) to earn profits from movements in the index level, diversify investment portfolios without making direct investments in the underlying stocks, and hedge portfolio risks.
Let us take the example of a hypothetical index 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. The index call option is priced at $15, so the entire contract price is $1,500 (= $15 x 100).
The premium paid in this transaction limits the downside risk to $1,500. The breakeven point of the index call option is determined by adding its strike price and the premium paid, resulting in 1,025 (= 1,010 + 15). Hence, the trade will be profitable above 1,025, with unlimited upside.
Types of Index Options
Primarily, the (IO) varies based on 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) They may also be differentiated based on the specific sector they focus on, e.g., industries like healthcare, banking, IT, etc.
Index Options List
The list below captures the symbol, description, and country of some of the most commonly traded (IO).
|HSI||Hang Seng||Hong Kong|
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 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 increase, 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 profit from the call options premium if the index goes down or from the underlying stocks if it goes up.
Index Options Symbols
The symbols below are statistical values 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 delta sensitivity per unit change in the underlying index.
- λ (Lambda): It measures the % change in the option’s value for a 1% change in the underlying index value.
- ρ (Rho): It measures the % change in the option’s value 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 option’s value for a 1% change in its volatility.
- Constructing them based on a large basket of stocks makes index options (IO) one of the best diversification alternatives available to investors.
- 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 compared to the delivery of stocks in the case of other options.
- Purchasing it involves a relatively lower investment than purchasing individual stock options.
- 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.
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.
This is a guide to Index Options. Here we discuss the introduction and how it works. Along with advantages and disadvantages. You may also have a look at the following articles to learn more –