What Is a Multi-Index Option?
A multi-index option is an outperformance option where the payoff is based on the relative performance of two indexes or other assets. The payoff from these exotic derivatives is determined by the change in the percentage price performance of one index or asset over another. They mainly trade in the over-the-counter (OTC) market.
Multi-index options are typically, but not required to be, European-style options, which can only be exercised at maturity and are settled in cash.
- A multi-index option is a derivative where the payoff value is based on the relative performance of one market index compared with another.
- These outperformance options typically measure the percentage change, or relative difference, in price over the life of the option rather than the dollar value.
- Multi-index options are considered to be exotic and trade only over the counter (OTC), settled in cash.
Understanding Multi-Index Options
Multi-index options are spread options where the payoff depends on a change in relative value rather than market direction. They are sometimes used by investors to hedge risks or to speculate on the relative performance of stock indexes, different issuers in the bond markets, or exchange rates—especially when there is no cross rate available to trade. They can also be relatively low cost, compared to vanilla index options.
It is worth noting that each index may have vastly different nominal prices. For example, if the S&P 500 is trading at $3,000 and the Dow Jones Industrial Average at $30,000—or 10x higher—the nominal spread is not a good measure of relative performance. The S&P 500 may gain $10 and the Dow $20 over the life of the option; however, the percentage gain for the former would be far greater than the latter. In this case, the S&P greatly outperformed the Dow over the life of the option although the gains in dollar terms were greater for the Dow. So multi-index often considers the percentage change of each at the start of the contract. The spread then looks at the increase or decrease in relative value between the two.
Uses for Multi-Index Options
Multi-index options have a few main uses. The first is to allow speculators to bet on the performance of two indices relative to one another. Speculators can choose two indices within a country, two county indexes, two sectors, etc.
Hedgers also find multi-index options useful for reducing risks across markets or asset classes. For example, equities in different countries may be affected by their own country's political landscape, interest rates, and/or currencies. If the holder believes both markets have similar prospects but one has additional risks due to their home market, the option can help mitigate that risk.
Example of a Multi-Index Option
For example, consider a multi-index option on the relative performance of the S&P 500 versus Canada's TSX Composite over a year. If the option has a strike price of 5%—the threshold between the option paying off or expiring worthless—then, if the S&P 500 has declined 2% but the TSX has declined 9% after a year, the option will have a positive payoff of 2% because the S&P 500 has outperformed the TSX by 7% points. If the S&P 500 outperforms by less than 5%, the option will expire being worthless.