Index options are options that allow investors to bet on whether an index as a whole will rise or fall.
An index that tracks a group of securities like stocks, often with factors such as their industry or size. And options allow investors to buy or sell the right to buy or sell at a set price. Learn more about the combination of the two, an index option, works and how you can use index options in your investment strategies.
Definition and Example of an Index Option
Like a traditional option, index options involve a premium (the amount that the buyer of the contract pays the seller) and a strike price (the price at which the contract owner can buy or sell the underlying security).
However, index options don’t give the option holder the right to buy every stock in an index. Index options use cash settlement instead. The two parties in the transaction simply exchange cash when the option is exercised or expires.
For example, say the S&P 500 is at 4,500 points. Jane decides to sell a call option to Tim with a strike price of 4,500. Tim pays a premium of $10. Just as a stock option typically covers 100 shares of a stock, index options typically use a multiplier of 100. So, in this case, Tim will pay $1,000 in total.
$10 * 100 = $1,000
Options are a form of leverage. Leverage increases not only your potential returns but also your risk, so you need to understand exactly how much money you’re risking and make sure you can afford the potential losses.
In our hypothetical example, if the S&P 500 gains value, Tim’s call option will increase in price. If it falls, the call option will fall in price. For instance, if it rises to 4,525, Tim could exercise the option to get a payment of $2,500.
(4,525 - 4,500) * 100 = $2,500
When Tim chooses to exercise his option, Jane and Tim will exchange money to settle the contract. However, if exercising the option would cause Tim to lose money, he’d likely simply let it expire, and no additional money would change hands. In this case, Jane profits from the premium Tim paid.
How Does an Index Option Work?
An index option works similar to a stock option, but there are some differences. Stock options are based on the value of an underlying stock. They’re essentially a promise for investors to complete a transaction at a set price in the future, assuming the option holder chooses to go through with the transaction.
Index options aren’t based on a single stock. Instead, they focus on the value of a stock index. There is no underlying share for the investors to exchange. Instead, these types of options are an agreement between investors to exchange cash based on the index’s value.
A Stock Option vs. an Index Option
Index options have several similarities compared to stock options, such as allowing investors to leverage their portfolios. Here are more details about stock options and index options.
|Stock Option||Index Option|
|Involves a premium, expiration date, and strike price||Involves a premium, expiration date, and strike price|
|Allows investors to leverage their portfolios||Allows investors to leverage their portfolios|
|Based on the value of one stock||Based on the value of a group of stocks in the form of an index|
|Option holder can exercise the contract to buy or sell a stock||Option holder can exercise the contract to receive a cash payment|
As you can see, stock options and index options are very similar. The primary difference is that a stock option involves buying and selling shares in a specific business. Index options are cash-settled, meaning no shares change hands. Instead, they’re simply a tool that investors can use to profit off predictions about indexes as a whole instead of their individual components.
What It Means for Individual Investors
For individual investors, index options offer a way to profit from predictions about the movement of a stock index rather than an individual stock. Keep in mind that options can be complicated and selling options can be very risky, so they may not be ideal for new traders.
If you’re interested in options trading, index options can provide opportunities to make profits if you understand the associated risks.
- Index options let investors try to profit off predictions about the future of an index of stocks.
- Index options are cash settled; investors don’t buy or sell shares in every business in the index.
- Like stock options, index options have a premium, a strike price, and an expiration date.