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Index Options 101 ( Best Comprehensive Guide for Beginners )

man and monitor with graphs

What is an Index Option?

Index options are collections of actual stocks grouped around a particular commodity or sector. They are typically used to gauge the performance of the commodity, sector or market they represent.

Examples of index options include the SPX, which represents the valuation of the stocks held in the S&P 500. This, however, is a broad market index. An example of a stock index is the SOX, which is a semiconductor index. The OIX, on the other hand, is an oil index which falls under the category of commodity related options indexes. To better understand how they work, you need a list of index options, which can be found here – index options list.

Index options, like stock options, are financial derivatives which draw their overall value from underlying assets. As such, they are derived from the value of underlying stock indices.

Holding an index option gives you the right to sell or buy a basket of stocks or an index – such as the NASDAQ or the S&P 500 – at a predetermined date and price. As an investor, therefore, you will be able to generate profits from expected moves in the market. You can also mitigate the risk of holding the instrument underlying in certain indexed funds.

Speculators and investors trade index options for purposes of gaining greater exposure in a specific industry or in the entire market with one transaction. To diversify your portfolio using individual stocks, you need numerous transactions and a copious amounts of capital. Although trading options will minimize the risk-related losses associated with index funds, you can easily use index options as a separate investment.

Pricing Index Options

a) Weighted Options

The way index options are valued varies. Some are known as price-weighted options, because their value is the sum of the total number of stocks making up the index.

b) Capitalization Weighing

This is another approach used to value index options. Here, the total capitalization of every stock in the index will be added together before being divided by a divisor amount reducing the total to a reasonable number.

To trade these index options successfully, you need to understand the differences between the valuing methods. This is because the difference will affect the movement of index options for various stocks, especially in the case of higher priced stocks.

More on Index Options

Many option indexes tend to trade options. To this end, index options trading is similar to trading stock options. The price of the option, for instance, will be derived from the volatility and the price of the underlying index. For most cases on contract therefore will still represent 100 shares of the index underlying.

American Style vs European Style Options

In case of trading European style options, the contract buyer cannot exercise the option prior to expiration. As a result, the option seller does not have to worry about early assignments – which can potentially cause problems if short positions get in the money. On the contrary, American style options, like the BKX index, can be exercised on or before the expiration date.

Most index options, however, are European style options. These include options on the Dow Jones 30 (DJX), Nasdaq 100 (NDX), S&P 500 (SPX), and the Russell 2000 (RUT).

Index Options Expiration and Settlement

When do index options expire? Basically, all stock options listed in the US stop trading on the 3rd Friday of the expiration month and settle at noon the following Saturday. The settlement value will be calculated based on the opening price of each component in the index on Friday morning.

So, does this pose potential problems to your trading accounts? And what lessons can you learn from it. Essentially, while trading index options, you need to:

a) Know how the options you are trading tend to behave

b) Ensure you never hold an option until its expiration

downward arrow graph

Cash Settlement

Index options are also settled for cash. This means that if assignments were to occur, you would not be forced to sell or buy the bond index options (depending on whether it is a call or a put assignment). Instead, you’d be required to settle in cash.

Let’s Look at an Example!

For instance, say you sell a naked $500 put on the RUT while it is trading at $530. By the close of Thursday the RUT was trading at $510 and you decide to hold the index until expiration (which is a bad idea). On Friday morning, you get bad news right before the market opens and hear that the RUT has gapped down by $15 and now has a settlement value of $495.

You won’t be assigned shares of the RUT simple because there will be no actual stock. Instead, you will have to pay the difference between the prices you put the RUT for ($500) and the final settlement price ($495). This means you have to pay the holder of the option $5 or $500 for every contract in the same position.

Watch This Video for More

Advantages of Trading Index Options

Trading index options comes with a number of advantages. With the issues stated above, you might wonder why investors and brokers trade these options at all. However, it does have its own unique benefits. These include, but are not limited to:

1. European Style Exercise

One advantage that you get trading index options is that these assets are European style exercise. This means that if there is a case where the position goes against you and you were in the money, you won’t be in danger of getting assigned. That is, unless you decide to hold the index options until expiration.

2. Better Tax Treatment

Another advantage of trading broad based bond index options is that you will get to enjoy improved tax treatment. This is because most of the options you will trade will fall under Section 1256 contracts, whereas most of the other option trades will fall under the short term capital gains category (15% to 35%).

Tax treatment under Section 1256 contracts is 40% short term and 60% long term. This will effectively lower your tax rates to around 23%. If you are trading index options in large volumes, you can be sure that this tax respite will make a great difference in the overall worth of your portfolio.

ETFs – Proxies for the Index

So, how can you get the best of both worlds? How can you trade against a specific sector or the broader market and not have to deal with the risks that are typically associated with trading index options?

Exchange Traded Funds (ETFs), like the RUT index, make this possible. Essentially, ETFs are stocks that are backed by the commodities or stocks they represent. Although this description isn’t 100% accurate, it should suffice for the purposes of this comprehensive guide for beginners. As with trading index options, you also need to understand the index fund options well before you start trading it.

Why Trade ETF Products

So, why should you trade these products? And how can you learn how to trade index options?

In most cases, investors and brokers like them because they:

  • Represent a broad commodity or sector they wish to trade
  • Behave like stocks in almost every way
  • Are typically highly liquid, meaning that the options themselves are also very liquid

Short List of ETFs

Following below is a short list exchange traded funds, as well as the index they track:

ETF INDEX
DIA DJX
SPY SPX
IWM RUT
QQQ NDX
GLD Gold
USO Oil

There are a number of other ETFs that you might want to trade. For these, you don’t need to track the broad market indices especially if they are regional or sector ETFs. Examples include Brazilian stocks (EWZ), Emerging Markets (EEM), Energy (XLE), and Financials (XLF).

The great thing about ETFs is that some of their groupings represent the short side of a given trade. Although this might not be beneficial to you while trading index options, it is still good to know that they do exist.

Basic Index Option Trading Strategies

If you wish to trade any kind of option (including index options), you have the choice between a put and a call strategy. Basically speaking, a call option will allow you to buy a basket of stocks at a given price (which is predetermined) expecting that the value of the index will appreciate.

bull and bear

A put option, on the other hand, will give you the right to sell that index option at a given strike price (also predetermined). Under this arrangement, you will be making the assumption that the value of that index will depreciate.

 

While trading stock index options, you won’t be selling or buying the physical stock index. Rather, the value of the option will move toward the same direction as that market index.

Buying index calls is referred to as bullish strategy. This is because the value of the call option will go up at the same time as the underlying index increases in value. On the other hand, buying index put options is called a bearish strategy. Here, the value of the put will go up whenever the value of any underlying asset depreciates.

The potential for profit in both cases will be limited to the underlying index decreasing or increasing to the strike price. In the same way, the financial risks for put and call options are limited to the total premium you paid for the option.

Advanced Index Option Trading Strategy

Anyway, buying call and put indices are basic index options strategies especially in comparison to the overall scale of index option trading that happens on a daily basis. More advanced strategies you can adopt as you understand index options more include collars and straddles.

1. Index Straddle

This is the option strategy index options involving the purchase of both an index put and an index call where both of the options have a similar strike price. When you buy index straddles, you would typically be anticipating index volatility either decreasing or increasing from its current level.

The potential profits will be leveraged, and may prove large when the underlying index moves significantly. The potential losses, on the other hand, will be determined at the point where the contracts have been established.

For a long straddle, the maximum loss will be the total put and call premiums paid. This would only occur if the underlying index value is equal to the strike price when the contracts expire.

2. Index Collars

This strategy involves selling index calls and buying a similar amount of index puts at the same time. The premiums you get when you sell calls will, to some extent, provide financing to pay for the index puts. This way, you will protect the value of your portfolio against adverse movements in the market.

The extent to which the premiums received from selling index calls will cover the index puts will depend on:

  • The strike price of the contracts you chose
  • The current level of the index underlying

You can implement an index collar when your portfolio has mixed stocks and you wish to protect its overall value and fecundity with puts on the underside. By using index collars, to this end, you will limit potential losses by index puts. At the same time, you can cap profits using the index calls.

Conclusion

All in all the losses and risks associated with trading index options are highly limited to the strike price and the premium paid when the contract was written. In the same way, these losses will act as the caps or the limits for any potential limits you can make by trading in this way.

Index options draw their appeal from their unique ability to generate a steady income for the long term investor while mitigating the risks of holding a portfolio with different asset classes.

Keep in mind that index options are mainly used to alleviate the risks that are typically associated with index funds. Index funds, being the leveraged products they are, have the potential for inflicting severe losses on an investor. This is why it is important to learn how to trade index options. Index options, therefore, are used to hedge for short and long term investors. In the same way, as an individual investment, they provide peace of mind and stability for less risky investors.

Editor’s Note

Diversify, diversify, diversify. Get your equities game on. Learn the ins and outs of trading stocks from one of the veterans in the business, John Thomas, founding father of hedge fund trading. Subscribe to his insights, webinars, and trade alerts. Sign up here.

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About Carol St. Amand

Carol St. Amand

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