One interesting twist on equity options is the index option, a call and put traded on an underlying index rather than a specific security. Essentially, the index option investor is making a bet that the market - as defined by a basket of stocks known as an index - will go up or down.

Types of Indexes
The most famous index is the Dow Jones Industrial Average, and the one that has been getting all the attention since the dot-com bubble is the Nasdaq. However, the Dow is focused entirely on large-cap companies, and the Nasdaq is weighted toward the technology sector.

Choosing an Index
Those who trade index options usually want to invest in the broader market, usually reflected in the S&P 500. But investors frequently want to refine their scope and invest in a narrower sector of the economy. In that case, they will invest in the Nasdaq if they want to focus on tech, or in other specialized indexes if they favor utilities, airlines, pharmaceuticals or any other industry.

Advantages
The advantage of investing in index options is that your client makes one purchase, thus incurring one set of transaction costs and avoiding a lot of the expense associated with buying shares of each of the companies that comprise the index.

Settlement
When exercised, of course, your client cannot settle up in "indexes". These options must be cash-settled. In other words, the exercise settlement value, as determined by the difference between the underlying index's position on that date as compared to the strike price of the contract, must be paid in cash. This is different from stock options, in which shares must be physically delivered at exercise.

Another difference between index options and stock options is where they are traded. Stock options, as noted before, are listed on the CBOE. Index options are listed on the American Stock Exchange, or Amex.

Capped Index Options
One flavor of index option is the capped index option - an index option that is automatically exercised when a "cap price" is reached or exceeded. If its cap price is not reached, a capped index option can be exercised only at its expiration. The cap itself has a value, which is calculated by Amex. Conceptually, this is easy to understand: a call writer can be wiped out if the value of the underlying index rises sharply, and may be willing to take a lower premium to avoid risking catastrophe. The value which, when added to the exercise price for a call or subtracted from the exercise price for a put, results in the cap price is called the cap interval.


Look Out!
There are capped stock options too, but they will not be covered on the Series 7 exam. The CBOE, which trades most stock options, emphasizes them less than the Amex, which trades most index options. Apparently, the Amex wants to make sure you know what a cap is.



Other Options

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. Investing

    ETF Options Vs. Index Options

    Choosing either ETF options or index options can make the difference between big profits or a big bust.
  3. 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.
  4. 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.
  5. Trading

    Getting Acquainted With Options Trading

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

    Three Ways to Profit Using Put Options

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

    4 Reasons To Hold Onto An Option

    There are times when an investor shouldn't exercise an option. Find out when to hold and when to fold.
Frequently Asked Questions
  1. Depreciation Can Shield Taxes, Bolster Cash Flow

    Depreciation can be used as a tax-deductible expense to reduce tax costs, bolstering cash flow
  2. What schools did Warren Buffett attend on his way to getting his science and economics degrees?

    Learn how Warren Buffett became so successful through his attendance at multiple prestigious schools and his real-world experiences.
  3. How many attempts at each CFA exam is a candidate permitted?

    The CFA Institute allows an individual an unlimited amount of attempts at each examination.Although you can attempt the examination ...
  4. What's the average salary of a market research analyst?

    Learn about average stock market analyst salaries in the U.S. and different factors that affect salaries and overall levels ...
Trading Center