Index options are derivatives whose underlying security is not a single stock but a basket of securities called an index. They provide investors with the opportunity to trade in options on the whole broad-based market without much hassle and with relatively little capital. Index options gained prominence in the 1980’s when portfolio hedging became an important concept and the Chicago Board Options Exchange (CBOE) has since increased their popularity. Strategies for trading index options are not so different from strategies for equity options, though there are some exceptions.

The underlying index for these options can be either a market capitalization-weighted index or an equal dollar-weighted index. The investor can either trade in broad-based indexes like S&P-500 or sector-specific indexes that may focus on industries like tech or healthcare.The most popular index options in the United States are the S&P 500 Index Options (CBOE:SPX), Russell 2000 Index Options, CBOE Volatility Index (CBOE:VIX), the Nasdaq-100 Index (NASDAQ:NDX) and the S&P-100 Index Options (CBOE:OEX).

Advantages of Index Options

There are various advantages for the common investor to trade in index options:

  • Diversification: The trader can gain exposure to a large number of securities with very little capital as compared to single stock options which are prone to company-specific risks.
  • Less volatility: A broad-based index is generally less volatile that single stock options. Single stocks can be affected by minor events like earnings reports, analyst reports or simply rumors. Indexes and subsequently index options are not so easily affected.
  • Liquidity: World over it has been observed that amongst all the option chains, the index options are the most liquid. Hence the general trader can usually find the right price and exit opportunity.
  • Predetermined loss/risk: As in all option trading, the maximum loss that an option buyer faces while dealing with options is the premium paid. Hence to a new trader, index options can be a good learning experience with leverage at very little risk.
  • Leverage: Traders like options because of the ability to use leverage. Leverage allows traders to apply correct analyses with very little capital. Traders can make bets on up to 10 times their available capital.
  • Relatively lower cost: The cost to trade a broad market is reduced compared to individual stock or equity options. Hence the trader is exposed to only market risk at very little cost with significant upside potential.

Unlike equity options, predominantly index-based options are cash settled. Physical settlement on a 500 stock index option would be a nightmare for the clearing exchange as getting 500 stocks to settle a single trade is cumbersome and almost impossible. Hence some of the basic options strategies (like covered call, which entails buying the underlying as well) are difficult to implement with index options

Pricing

Index options are priced in the same way as general options, usually by the Black-Scholes formula. The price of an option depends on the following variables: volatility, time to expiry, current value of underlying index, strike price and interest rates. Index options being the most liquid of all options, are a favorite of arbitrage traders as they can use them to earn considerably risk-free returns.

Different Types of Index Options

Index options can also be classified based on the duration of the option. Below is the table suggesting the various options on the S&P-500 traded on the Chicago Board Options Exchange.

Option Description Notional Number of Units Settlement
SPX (Settled on 3rd Fridays) 100 Cash
SPX Weekly’s (Settled at the end of each week) 100 Cash
SPX End of Month 100 Cash
Mini-SPX 10 Cash

Based on the duration, these S&P-500-based indexed options can be classified as weekly, monthly or quarterly options. Each of these options represents a notional value equal to 100 units of the index. The fourth option is the Mini-SPX options which represents a notional value of 10 units of the index. Leaps can also be categorized as a type of long-term index option. SPX short-term options are quoted at intervals of 5 points. This is extended to 25 points in case of LEAPS.

The options are also classified based on the strike price in to three categories as follows: in-the-money, at-the-money and out-of-the-money.

As an example, assume the index is quoting at around 1800 levels. The call option with the strike price of 1750 will be called the in-the-money option. The one with strike price of 1800 will be the at-the-money option and the one with a strike price of 1850 will be the out-of-the-money option.

An index option gives the holder certain contractual rights according to the standard agreement. These generally include right to exercise an option and to settle the options in cash on the exercise date.

The Index options can also be classified as either European- or American-style options based on the date of settlement. Most of the index options are cash-settled European style options barring a few. In European style options, the option can be exercised only at the expiration date. In most countries, settlement is done on the day after expiration, in cash. Calculation of index levels for settlement differ from country to country. Most of the options use the index value on the expiration date as the settlement price. Index options can be classified as a.m. or p.m. settled. A.m. settlement is based on the opening price of the index as the settlement price, whereas in p.m. settlement, as the name indicates, settlement price is based on the closing price of the index. There are certain variations in calculating the closing price as well. This can either be the last traded price or the weighted price of the index in the last 30 minutes of trading.

Taxation

The taxation on gains derived from index options trading differ from country to country. In the United States, index options fall under the category of a 1256 contract according to Internal Revenue Service.A 1256 contract according to IRS is a list of contracts which are treated as marked-to-market at end of year based on their fair value and are then taxed accordingly. Hence 60% of the total capital gain is treated as long-term gain and 40% of the gain is treated as short-term gain. In other countries (like India, for example) all gain from index options are treated as short-term gain if the option is held for less than one year.

The Bottom Line

Index options are a great way for the novice trader to learn the basics of option investing. High liquidity and lowered risk make them a fertile ground for learning the ins and outs of option trading.

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