Similar to stock options, index options are financial derivatives that draw their value from an underlying asset. In this case, index options are derived from the value of an underlying stock index. Like an option, the holder of an index option has the right to buy or sell an index or basket of stocks, such as the S&P 500 or NASDAQ, at a predetermined price and date. Investors generate profits from an expected move in the market or mitigate the risk of holding the underlying instrument in particular indexed funds.

Investors and speculators trade index options in order to obtain exposure in the entire market or specific industry with a single transaction. Obtaining diversification with individual stocks requires large amounts of capital and a number of transactions. While trading options can help minimize risk related losses with index funds, index options can be utilized as their own separate investment.

Basic Strategy

When trading any kind of options, including index options, investors have the choice between a call and put strategy. A call option, with respect to indexes, allows the investor to buy a basket of stocks at a predetermined price with the expectation that the value of the index will rise. Conversely, a put option gives the investor the right to sell an index at a predetermined strike price. Under this assumption the investor believes the value of the index will decrease. When utilizing options the investor is not buying or selling the physical stock index; however, the value of the option will move in the same direction as the market index.

Buying an index call is a bullish strategy as the value of the call option increases as the value of the underlying index rises. Conversely, buying an index put is a bearish strategy. The value of the put increases as the value of the underlying asset decreases. Profit potential in both cases is limited to the underlying index increasing or decreasing to the strike price. The financial risks for call and put options are limited to the total premium paid for the option. Buying put and call indexes are basic strategies in index option trading, with more advanced strategies including straddle and collars. (For more, see: 10 Options Strategies To Know.)

Index Straddle

An index straddle is an option strategy which involves purchasing both an index call and index put with both options having the same strike price. Investors who purchase index straddles anticipate index volatility either increasing or decreasing from its current level. Potential profits are leveraged and may be large with any big movements in the underlying index. The potential losses for index straddles are determined at the point the contracts are established. The maximum loss for a long straddle is the total call and put premiums paid. This would occur if the value of the underlying index equals the strike price as the contracts expire. (For more, see: Profit On Any Price Change With Long Straddles.)

Index Collars

An index collar is an option strategy that consists of selling index calls while simultaneously buying an equal number of index puts. The premiums from selling calls, in part, finance the cost of index puts. This will help protect the value of the portfolio against any adverse market movements. The degree to which the premiums from index calls covers index puts depends on the current level of the underlying index and strike prices of the contracts chosen. An index collar is implemented when an investor owns a portfolio of mixed stocks and wants to protect its value with puts on the downside. When utilizing index collars, potential losses are limited by index puts while profits are capped by index calls. (For more, see: Market Volatility Strategy: Collars.)

Bottom Line

In general, risks and losses associated with index option trading are limited to the premium paid and the strike price agreed upon when the contract is written. Likewise these losses are also the potential limits for profits as well. An Index option draws its appeal from its ability to mitigate risks and for long term investors can generate steady income. The main purposes of index options are to alleviate risks associated with index funds. As a leveraged product, index funds have the potential for severe losses that index options can hedge for long and short term investors. However as an individual investment, index options can provide stability and peace of mind for less risky investors.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.