A:

Index options are financial derivatives based on stock indices such as the S&P 500 or the Dow Jones Industrial Average. 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.

Index options are classified as European-styled rather than American for their 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. 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. 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. 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. 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.

RELATED FAQS
  1. Do you have to be an expert investor to trade put options?

    Learn about investing in put options and the associated risks. Explore how options can provide risk, which is precisely defined ... Read Answer >>
  2. What options strategies are best for investing in the industrial sector?

    Learn a couple of popular options trading strategies that can be used by investors seeking to enhance their profits from ... Read Answer >>
  3. When does one sell a put option, and when does one sell a call option?

    The incorporation of options into all types of investment strategies has quickly grown in popularity among individual investors. ... Read Answer >>
  4. When holding an option through expiration date, are you automatically paid any profits, ...

    Holding an option through the expiration date without selling does not automatically guarantee you profits, but it might ... Read Answer >>
Related Articles
  1. Trading

    How to Make Money by Trading Index Options

    Index options are less volatile and more liquid than regular options. Understand how to trade index options with this simple introduction.
  2. Trading

    Index Options: A How-To Guide

    Index options, financial derivatives that derive their value from a stock index, can provide stability and peace of mind for less risky investors.
  3. Trading

    Three Ways to Profit Using Put Options

    A brief overview of how to profit from using put options in your portfolio.
  4. Trading

    A Guide Of Option Trading Strategies For Beginners

    Options offer alternative strategies for investors to profit from trading underlying securities, provided the beginner understands the pros and cons.
  5. Trading

    Options Hazards That Can Bruise Your Portfolio

    Learn the top three risks and how they can affect you on either side of an options trade.
  6. Trading

    Exploring European Options

    The ability to exercise only on the expiration date is what sets these options apart.
  7. Investing

    ETF Options Vs. Index Options

    Choosing either ETF options or index options can make the difference between big profits or a big bust.
RELATED TERMS
  1. Compound Option

    An option for which the underlying is another option. Therefore, ...
  2. Call On A Call

    A type of compound option in which the investor has the right ...
  3. In The Money

    1. For a call option, when the option's strike price is below ...
  4. European Option

    An option that can only be exercised at the end of its life, ...
  5. Option Class

    The set of all the call options or all the put options for a ...
  6. Stock Option

    A privilege, sold by one party to another, that gives the buyer ...
Hot Definitions
  1. Agency Theory

    A supposition that explains the relationship between principals and agents in business. Agency theory is concerned with resolving ...
  2. Treasury Bill - T-Bill

    A short-term debt obligation backed by the U.S. government with a maturity of less than one year. T-bills are sold in denominations ...
  3. Index

    A statistical measure of change in an economy or a securities market. In the case of financial markets, an index is a hypothetical ...
  4. Return on Market Value of Equity - ROME

    Return on market value of equity (ROME) is a comparative measure typically used by analysts to identify companies that generate ...
  5. Majority Shareholder

    A person or entity that owns more than 50% of a company's outstanding shares. The majority shareholder is often the founder ...
  6. Competitive Advantage

    An advantage that a firm has over its competitors, allowing it to generate greater sales or margins and/or retain more customers ...
Trading Center