Index Options

In an effort to gauge the market’s overall performance, industry participants developed indexes. Two of the most widely followed indexes are the Dow Jones Industrial Average and the Standard and Poor’s 500. There are two types of indexes: broad based indexes such as the S & P 500 (SPX) or S & P 100 (OEX) that track a large number of stocks, and narrow based indexes such as the semiconductor index (SOX) that track only a particular industry. The following table details some of the more popular indexes an investor can trade options on:

Broad Based Indexes                                     Narrow Based Indexes

S & P 500 / SPX

Semiconductor Index / SOX

S & P 100 / OEX

Oil Index / OIX

Dow Jones Industrials / DJX

Pharmaceutical Index / DRG

NASDAQ 100 / NDX

Computer Technology / XCT

Index Option Settlement

Investors who want to take a position in index options will purchase calls and puts just like investors in stock options. However, an index is not a security and cannot be physically delivered if the option is exercised. An investor cannot call the index away from someone who is short a call and cannot put an index to an investor who is short a put. As a result, the exercise of index options will be settled in cash. An option holder who elects to exercise the option will have their account credited the in the money amount, in cash. The amount that will be credited to their account will be the in the money amount at the close of the market on the day of exercise. The exercise of an index option settles between broker dealers on T + 1 and customer accounts will be credited or debited accordingly. To determine the option’s premium and the amount of money to be delivered upon exercise index options, use 100 as a multiplier.

Example:

An investor establishes the following position: Long 1 OEX March 550 call at $4

The investor has purchased an S & P 100 (OEX) 550 call for $4. The contract value is

55,000 and the total premium paid by the investor is $400. The investor is bullish on the

overall market and believes the market will rise and the OEX will be higher than 550 by expiration.

If at expiration, the index is at 556.20, the investor will have their account credited the in the money amount as follows:

556.20 -550.00 = 6.20. ,6.20 x 100 =$620.00

The investor’s account will be credited $620. Since the investor paid $400 for the option their profit is $220.

Exercising an Index Option

It is usually not wise to exercise an index option prior to its expiration because the investor would lose any amount of time value contained in the options premium. Additionally, if the investor exercises their option at 10:00 AM the investor will receive the in the money amount, as of the close of the market that day. It is quite possible for an investor to exercise their in the money option at 10:00 AM and have the option be out of the money at the close of business because the market moved against them. In both scenarios, it is better to sell the option.

Index Option Positions

An investor may establish all of the following positions using index options:

  • Long Calls and Puts
  • Short Calls and Puts
  • Long Spreads and Straddles
  • Short Spreads and Straddles
  • Long and Short Combinations

Index options may also be used to:

  • Speculate on the direction of the market
  • Protect a long portfolio by purchasing puts or selling calls
  • Protect a short portfolio by purchasing calls or selling puts

Capped Index options

A capped index option trades like a spread and will automatically be exercised if the underlying index closes above the capped price. Capped index options have a 30-point cap and look as follows:

Buy 1 OEX June 550 call

Sell 1 OEX June 580 call

If the OEX index closed above 580 at any point during the life of the option both options will be exercised and credited the in the money amount. In the above example, 580 would be known as the capped price. An investor can also traded capped put options in a similar manner. A capped put option would look as follows:

Buy 1 OEX May 600 Put

Sell 1 OEX May 570 Put

In this case the capped option would automatically be exercised if the OEX closed below

570 at any point during the life of the option. With a capped put option the lower strike

price is known as the capped price.

 

 

FOREIGN CURRENCY OPTIONS

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