Index Option

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.

RELATED TERMS
  1. Mini-Sized Dow Options

    A type of option for which the underlying assets are Dow Jones ...
  2. Call On A Put

    One of the four types of compound options, this is a call option ...
  3. Call On A Call

    A type of compound option in which the investor has the right ...
  4. Call Option

    An agreement that gives an investor the right (but not the obligation) ...
  5. Stock Option

    A privilege, sold by one party to another, that gives the buyer ...
  6. European Option

    An option that can only be exercised at the end of its life, ...
Related Articles
  1. Markets

    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

    Index Options and Mini Index Options

    Index options allows a trader to wager on the movement of an entire stock market index, such as the Dow Jones or the S&P 500 index, rather than just an individual security.
  3. ETFs & Mutual Funds

    ETF Options Vs. Index Options

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

    Getting Acquainted With Options Trading

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

    Three Ways to Profit Using Call Options

    A brief overview of how to provide from using call options in your portfolio.
  6. 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.
  7. ETFs & Mutual Funds

    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.
  8. Trading

    Options Pricing: A Review Of Basic Terms

    The following is intended as a review of basic option terminology, which can be used as a reference as needed: American Options - An option that can be at any point during the life of the contract. ...
  9. 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.
  10. Investing

    Types of Options

    There are many different types of options. In addition to general put options and call option, we will discuss 13 different types of options. Some of these option types are better suited to day ...
RELATED FAQS
  1. What is index option trading and how does it work?

    Learn about stock index options, including differences between single stock options and index options, and understand different ... 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. 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 >>
  4. How do I change my strike price once the trade has been placed already?

    Learn how the strike prices for call and put options work, and understand how different types of options can be exercised ... Read Answer >>
  5. 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 >>
  6. What is the difference between "right" and "obligation" on a call option?

    Learn what a call option is, what determines a buyer and seller of an option, and what the difference between a right and ... Read Answer >>
Hot Definitions
  1. Duration

    A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. ...
  2. Dove

    An economic policy advisor who promotes monetary policies that involve the maintenance of low interest rates, believing that ...
  3. Cyclical Stock

    An equity security whose price is affected by ups and downs in the overall economy. Cyclical stocks typically relate to companies ...
  4. Front Running

    The unethical practice of a broker trading an equity based on information from the analyst department before his or her clients ...
  5. After-Hours Trading - AHT

    Trading after regular trading hours on the major exchanges. The increasing popularity of electronic communication networks ...
  6. Omnibus Account

    An account between two futures merchants (brokers). It involves the transaction of individual accounts which are combined ...
Trading Center