Index options market index give the investor the right to buy or sell the underlying stock index for a defined time period.
Since index options are based on a large basket of stocks earnings on trading for small amounts the index, investors can easily diversify their portfolios by trading them. Index options are cash settled when exercised, as opposed to options on single stocks where the underlying stock is transferred when exercised.
While not all trades on index options are used to hedge, the diversified portfolio of assets underlying index options makes them an appealing resource for portfolio management. In general, indices have more stability in price movements and their natural diversification lowers the burden on analysts to anticipate pricing. Instead of hedging every individual stock and tracking the positions in a large portfolio, portfolio managers can hedge large groups of securities with one instrument and prioritize new profit-driving positions over risk-reduction positions. Index options are also more liquid than their equity-based counterparts, making a position with them less exposed to the risk of slippage.
Index options are classified as European-styled rather than American for options market index exercise. European-styled options may only be exercised upon expiration, while American options can be exercised at any time up until expiration.
Index options are flexible derivatives and can be used for hedging a stock portfolio consisting of different individual stocks or for speculating on the future direction of the index.
Investors can use numerous strategies with index options. The easiest strategies involve buying a call or put on the index.
To make a bet on the level of the index going up, an investor buys a call option outright. To make the opposite bet on the index going down, an investor buys the put option. Related strategies involve buying bull call spreads and bear put spreads.
Glossary What is an Index Option? Like stock options, index option prices rise or fall based on several factors, like the value of the underlying security, strike price, volatility, time until expiration, interest rates and dividends. Difference 1: Multiple underlying stocks vs. Narrow-based indexes are based on specific sectors like semiconductors or the financial industry, and tend to be composed of relatively few stocks. Broad-based indexes have many different industries represented by their component companies.
A bull call spread involves buying a call option at a lower strike price, and then selling a call option at a higher price. The bear put spread is the exact opposite. By selling an option further out of the money, an investor spends less on the option premium for the position.
These strategies allow investors to realize a limited profit if the index moves up or down but risk less capital due to the sold option. Investors may buy put options to hedge their portfolios as a form of insurance. A portfolio of individual stocks is likely highly correlated with the stock index it is part of, meaning if stock prices decline, the larger index likely declines.
Index Options Explained
Instead of buying put options for each individual stock, which requires significant transaction costs and premium, investors may buy put options on the stock index. This can limit portfolio loss, as the put option positions gain value if the stock index declines.
Therefore, you should consider which vehicle offers the best opportunity in terms of option liquidity and bid-ask spreads.
The investor still retains upside profit potential for the portfolio, although the potential profit is decreased by the premium and costs for the put options. Another popular strategy for index options is selling covered calls.
Investors may buy the underlying contract for the stock index, and then sell call options against the contracts to generate income. For an investor with a neutral or bearish view of the underlying index, selling a call option can realize profit if the index chops sideways or goes down.
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If the index continues up, the investor profits from owning the index but loses money on the lost premium from the sold call. This is a more advanced strategy, as the investor needs to understand the position delta between the sold option and the underlying contract to fully ascertain the amount of risk involved. Compare Accounts.