The main problem associated with the above models in pricing the index options is how to account for the dividends associated with different stocks in the basket of the index.
Another way is to use dividend yield published by data sources like Bloomberg.
Depending on that, either party can terminate the options contract by paying cancellation charges as agreed by both parties. The calculation involved in Valuation is similar to the pricing of the option.
Parameters such as volatility, time to expiry risk-free rate of return keeps on changing depending on how financial markets are working. To get this right to buy, Firm A will have to pay some upfront amount known as Option Premium.
What is an Index Option?
The contract expires after fixed expiry date, i. Diversification: Index options are based on a large basket of stocks. This gives an easy diversification alternative to the investors.
Volatility: Index options are less volatile, hence easier to predict Liquidity: Since Index options are popular among traders, hedge fundsand investment firms, the volume available for trading is enough to keep the bid-ask spread in check, and prices are very close to a fair price. Cash Settlements: Index options are cash-settled. This makes settlements easier as opposed to the actual delivery of stocks in stock options.
Relatively low-cost investment alternative than to buy individual stock options Disadvantages of Index Options Below are the limitations of Index options. Index options being a little less rewarding, may not be attractive for investors who are willing to take on higher risks for more what is an index option.
Glossary What is an Index Option?
The pricing models for options are very complex, and to account for underlying like indices, it becomes way too complex to price. Conclusion Index options can be used for hedging a portfolio of individual stocks or for speculating the future movement of the index.
Investors can implement various option trading strategies with index options viz. Bull spreadsbear spreadscovered calls, protective puts. These strategies may lead to lesser profits, but the risk is minimized greatly.
Index options 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 in 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.
Here we discuss the types of index options, how it is priced along with calculation examples, advantages, and disadvantages. You can learn more about derivatives from the following articles —.