A:

Index options are financial derivatives based on stock indices such as the S&P 500 or the Dow Jones Industrial Average. Index options give the investor the right to buy or sell the underlying stock index for a defined time period. Since index options are based on a large basket of stocks in the index, investors can easily diversify their portfolios by trading them. Index options are cash settled when exercised, as opposed to options on single stocks where the underlying stock is transferred when exercised.

Index options are classified as European-styled rather than American for their exercise. European-styled options may only be exercised upon expiration, while American options can be exercised at any time up until expiration. Index options are flexible derivatives and can be used for hedging a stock portfolio consisting of different individual stocks or for speculating on the future direction of the index.

Investors can use numerous strategies with index options. The easiest strategies involve buying a call or put on the index. To make a bet on the level of the index going up, an investor buys a call option outright. To make the opposite bet on the index going down, an investor buys the put option. Related strategies involve buying bull call spreads and bear put spreads. A bull call spread involves buying a call option at a lower strike price, and then selling a call option at a higher price. The bear put spread is the exact opposite. By selling an option further out of the money, an investor spends less on the option premium for the position. These strategies allow investors to realize a limited profit if the index moves up or down but risk less capital due to the sold option.

Investors may buy put options to hedge their portfolios as a form of insurance. A portfolio of individual stocks is likely highly correlated with the stock index it is part of, meaning if stock prices decline, the larger index likely declines. Instead of buying put options for each individual stock, which requires significant transaction costs and premium, investors may buy put options on the stock index. This can limit portfolio loss, as the put option positions gain value if the stock index declines. The investor still retains upside profit potential for the portfolio, although the potential profit is decreased by the premium and costs for the put options.

Another popular strategy for index options is selling covered calls. Investors may buy the underlying contract for the stock index, and then sell call options against the contracts to generate income. For an investor with a neutral or bearish view of the underlying index, selling a call option can realize profit if the index chops sideways or goes down. If the index continues up, the investor profits from owning the index but loses money on the lost premium from the sold call. This is a more advanced strategy, as the investor needs to understand the position delta between the sold option and the underlying contract to fully ascertain the amount of risk involved.

RELATED FAQS
  1. 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 >>
  2. When does one sell a put option, and when does one sell a call option?

    An investor would sell a put option if her outlook on the underlying was bullish, and would sell a call option if her outlook ... Read Answer >>
  3. What is spread hedging?

    Learn about one of the most common risk-management strategies options traders use, called spread hedging, to limit exposure ... Read Answer >>
Related Articles
  1. Trading

    Index Options: A How-To Guide

    Index options, financial derivatives that derive their value from a stock index, can provide stability and peace of mind for less risky investors.
  2. Trading

    Three Ways to Profit Using Put Options

    A brief overview of how to profit from using put options in your portfolio.
  3. Investing

    ETF Options Vs. Index Options

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

    Trading Options on Futures Contracts

    Futures contracts are available for all sorts of financial products, from equity indexes to precious metals. Trading options based on futures means buying call or put options based on the direction ...
  5. Trading

    Exploring European Options

    The ability to exercise only on the expiration date is what sets these options apart.
  6. Trading

    American Vs. European Options

    These two options have many similar characteristics, but it's the differences that are important.
RELATED TERMS
  1. In The Money

    1. For a call option, when the option's strike price is below ...
  2. Call On A Call

    A type of compound option in which the investor has the right ...
  3. Bullet Trade

    A bullet trade is a secondary market trade that involves the ...
  4. Option Class

    The set of all the call options or all the put options for a ...
  5. Currency Option

    A contract that grants the holder the right, but not the obligation, ...
  6. American Option

    An option that can be exercised anytime during its life. American ...
Hot Definitions
  1. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its current share price relative ...
  2. Internal Rate of Return - IRR

    Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments.
  3. Limit Order

    An order placed with a brokerage to buy or sell a set number of shares at a specified price or better.
  4. Current Ratio

    The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations.
  5. Return on Investment (ROI)

    Return on Investment (ROI) is a performance measure used to evaluate the efficiency of an investment or compare the efficiency ...
  6. Interest Coverage Ratio

    The interest coverage ratio is a debt ratio and profitability ratio used to determine how easily a company can pay interest ...
Trading Center