What is an 'Index Option'

An index option is a financial derivative that gives the holder the right, but not the obligation, to buy or sell the value of an underlying index, such as the Standard and Poor's (S&P) 500, at the stated exercise price on or before the expiration date of the option. No actual stocks are bought or sold; index options are always cash-settled.

BREAKING DOWN 'Index Option'

Index call and put options are simple and popular tools used by investors, traders and speculators to profit on the general direction of an underlying index while putting very little capital at risk. The profit potential for long index call options is unlimited, while the risk is limited to the premium amount paid for the option, regardless of the index level at expiration. For long index put options, the risk is also limited to premium paid, and the potential profit is capped at the index level, less the premium paid, as the index can never go below zero.

Beyond potentially profiting from general index level movements, index options can be used to diversify a portfolio when an investor is unwilling to invest directly in the index's underlying stocks. Index options can also be used in multiple ways to hedge specific risks in a portfolio. American style index options can be exercised at any time before the expiration date, while European style index options can only be exercised on the expiration date.

Index Option Examples

Imagine a hypothetical index called Index X, which has a level of 500. Assume an investor decides to purchase a call option on Index X with a strike price of 505. With index options, the contract has a multiplier that determines the overall price. Usually the multiplier is 100. If, for example, this 505 call option is priced at $11, the entire contract costs $1,100, or $11 x 100. It is important to note the underlying asset in this contract is not any individual stock or set of stocks but rather the cash level of the index adjusted by the multiplier. In this example, it is $50,000, or 500 x $100. Instead of investing $50,000 in the stocks of the index, an investor can buy the option at $1,100 and utilize the remaining $48,900 elsewhere.

The risk associated with this trade is limited to $1,100. The breakeven point of an index call option trade is the strike price plus the premium paid. In this example, that is 516, or 505 plus 11. At any level above 516, this particular trade becomes profitable. If the index level was 530 at expiration, the owner of this call option would exercise it and receive $2,500 in cash from the other side of the trade, or (530 - 505) x $100. Less the initial premium paid, this trade results in a profit of $1,400.

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