Derivatives - Index Options
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.
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.
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.
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.