Options whose underlying asset is an index instead of stocks or a hard asset.
Index Options - Introduction
Options allow their holders to either purchase or sell the underlying asset at a fixed price. As such, options are usually used for trading hard assets such as stocks or commodities. This is where index options become puzzling. The underlying asset of Index Options are indexes. An index is simply an average number that represents the average performance of a basket of underlying assets. This means that an index is not an asset on its own but a performance indicator of a basket of assets. If that's the case, what is index options really about?
This tutorial shall explain in detail what index options are in options trading as well as its pros and cons.
Indeed, there is no way to understand Index Options in options trading without understanding what an index is in the first place. An index, like the S&P500, is a number derived from the average performance of a basket of stocks. There are many kinds of index; Broad market index such as the S&P500 tracks a huge number of stocks across all industries in order to arrive at a number that indicates overall market performance and there are other industry specific index such as the Dow Jones 20 Transport Index that tracks stocks in the transportation industry. As you might have understood by now, an index is simply a number that represents the performance of a group of stocks. So how does that become a tradable asset and how are index options created and traded?
Really, What Is The Underlying Asset Of Index Options?
Basically the act of trading index through index options is really a betting game on where the index will be in the future. Winners are settled by cash and losers delivers cash. The "index" itself isn't a part of the whole process of delivery at all. This is why Index options are known as Cash Settled options in options trading and are usually European Style Options. This means that even if you exercise the option, you are given cash back equal to the difference between the index price and the strike price. You do not own the "index" when you exercise index options at all. In this perspective, trading index options is akin to horse betting where there really isn't any "underlying asset" being delivered/traded. Yes, the underlying asset covered by index options is actually cash equal to the index level multiplied by 100 and not the "index itself".
Please take note that different countries, exchanges or index options may have different standards of conversion. Always check the specifications of the particular index option you are trading with the CBOE or your local authorities.
This makes trading index options very different from trading options of ETFs which tracks indexes. One of the most popular optionable ETF that tracks an index is the QQQQ that tracks the Nasdaq-100 index. When you exercise call options of ETFs that track indexes, you actually get delivered shares of that ETF instead of cash because the ETF itself is a tradable financial instrument unlike an index.
What Are Index Options?
Stock options are options with stocks as their underlying asset and delivers stocks when call options are exercised. Index options are options with an index as their underlying asset which is then converted to and settled with cash when index options are exercised. As index options are usually based on equity indexes, it is also known as equities index options.
Like stock options, index options comes with call options and put options as well, allowing investors to speculate on the direction of its underlying index. Similar to stock options, index call options gain in value as their underlying index rises and index put options gain in value as their underlying index falls. In fact, index options trade exactly like stock options and have almost all the same specifications in terms of premium, strike price, class and type.
There are also Index Options that are only one-tenth the size, known as "Mini Index Options".
Differences between Index Options and Stock Options
There are two main important differences between index options and stock options in options trading. 1, unlike stock options, index options are only settled in cash when exercised. 2, price level of indexes are usually determined at the end of the trading day. It is not continuously updated throughout the day like stocks are, which is why index options are usually closed after market hours. Other smaller differences are that index options have a much longer life span than stock options, going out as far as 10 years from trade date.
Benefits of Trading Index Options
Index options are a good diversification instrument because indexes do not suffer from idiosyncratic risk, which is the risk of a company doing badly when single company stocks are purchased, or secondary risk, which is the risk of an industry not doing well if index options of broad market indexes such as the S&P500 is traded.
Disadvantages of Index Options
The main disadvantage of index options is the fact that these options do not give their holder the right to purchase all the stocks that makes up the index. Even though they are known as "index options", they are really just "cash options" that bets on a representative number, which is an index. There are no tangible assets behind the options.
Important Disclaimer :
Options involve risk and are not suitable for all investors.
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