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 options make more sense during bull or bear markets?

    Understand how options may be used in both bullish and bearish markets, and learn the basics of options pricing and certain ... Read Answer >>
  2. How can derivatives be used to earn income?

    Learn how option selling strategies can be used to collect premium amounts as income, and understand how selling covered ... Read Answer >>
  3. Are put options more difficult to trade than call options?

    Learn about the difficulty of trading both call and put options. Explore how put options earn profits with underlying assets ... Read Answer >>
  4. 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 >>
  5. 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 >>
  6. How are call options priced?

    Learn how aspects of an underlying security such as stock price and potential for fluctuations in that price, affect the ... Read Answer >>
Related Articles
  1. 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.
  2. 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.
  3. 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.
  4. Trading

    Getting Acquainted With Options Trading

    Learn more about stock options, including some basic terminology and the source of profits.
  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. Investing

    ETF Options Vs Index Options

    Investors have much to consider when they’re deciding between ETF and index options. Here's help in making the decision.
  7. Trading

    Options Pricing

    Options are valued in a variety of different ways. Learn about how options are priced with this tutorial.
RELATED TERMS
  1. Index Option

    A financial derivative that gives the holder the right, but not ...
  2. Compound Option

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

    One of the four types of compound options, this is a "put" option ...
  4. In The Money

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

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

    An option that can be exercised anytime during its life. American ...
Hot Definitions
  1. Current Assets

    A balance sheet account that represents the value of all assets that can reasonably expected to be converted into cash within ...
  2. Tax Liability

    The total amount of tax that an entity is legally obligated to pay to an authority as the result of the occurrence of a taxable ...
  3. Preferred Stock

    A class of ownership in a corporation that has a higher claim on its assets and earnings than common stock. Preferred shares ...
  4. Net Profit Margin

    Net Margin is the ratio of net profits to revenues for a company or business segment - typically expressed as a percentage ...
  5. Gross Margin

    A company's total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. ...
  6. Current Ratio

    The current ratio is a liquidity ratio measuring a company's ability to pay short-term and long-term obligations, also known ...
Trading Center