Index Options Primer

Index options are an important financial instrument that allows investors to profit from the movement of an underlying index without having to trade individual stocks. In this article, we will explore the definition and differences between index options and stock options, how index options trades work, the benefits of trading index options, and the different types of options for indexes.

What are index options?

Definition of index options

An index option is a financial derivative that gives the option buyer the right, but not the obligation, to buy or sell an underlying index at a specified price, known as the strike price, on or before a predetermined date, known as the expiration date. The underlying index represents a group of stocks that are selected to represent a specific market or industry.

 An index like the S&P 500 represents 500 companies in the US for example.  The index itself is not tradable since it is a mathematical construct to represent these 500 companies.  Thus, you need to trade in an instrument that replicates the index like an ETF such as the SPY.   This ETF, called SPY, is run by State Street Global Advisors and is constructed to closely mimic after expenses (very low at less than 0.01%) the price the S&P500 Index.

In fact, ETFs are an efficient trading vehicle allowing traders and investors to quickly enter an exit with low costs.  In addition, highly liquid ETFs such as the SPY have very tight bid-ask spreads if you want to buy or sell just like the most liquid stocks.  In addition, option traders find the SPY ideal since it has very deep and liquid option contracts based on the SPY.  This means it is an ideal trading vehicle for investors, option traders and even hedge funds that want speculate or hedge their portfolios.   The options on the ETFs are based on American Settlement meaning you can get in and out of the position anytime before the expiration date.  Thus ideally suited for speculation and hedging purposes.

Popular ETFs the replicate the major indices include SPY (SPDR S&P 500 Trust),  IWM (iShares Russell 2000) and QQQ (Powershares QQQ Trust).  The important point is that ETFs are created and run by companies such as State Street Global Advisors, Blackrock and Powershares.  

The alterntive to using ETFs is index futures that are mainly used by larger investors such as mutual funds, asset managers and hedge funds.  Popular index futures are SPX (S&P 500),  RUT (Russell 2000), and NDX (Nasdaq 100). 

A futures contract requires a margin that represents a percentage of the total value of the asset.  The margin requirement is marked to market, meaning it is adjusted daily, thus if the position goes against you then you need to deposit more money to get back to the intitial margin requirement.   Therefore, you need to keep a very close eye on your position daily.  The amounts of money needed for the margin are beyond the typical investor or trader. 

The Futures Exchanges have created mini contracts to appeal to smaller traders and inverstors, but keep in mind that these instruments were designed for the needs of larger institional players like mutual funds and asset managers. 

There are option contracts on Index Futures and the decision to trade Index Future options compared to ETF index options comes down more to tax reasons and in general for the average trader or investor ETFs are more popular.  In addition, options on Index Futures are based on European Settlement, meaning a specific date in the future and as a trader you loose the flexibility to get in or out of the postion during the life of the contract. 

Differences between index options and stock options

While stock options provide the option holder the right to buy or sell an individual stock, index options are based on the value of an underlying stock market index. This means that index options allow investors to trade the movement of the broader market rather than focusing on individual stocks. This can be beneficial for diversification and risk management purposes.

How do index options trades work?

When trading index options, investors can choose to buy or sell call or put options. A call option gives the option holder the right to buy the underlying index at the strike price, while a put option gives the option holder the right to sell the underlying index at the strike price. These options can then be bought or sold on an options exchange, such as the Chicago Board Options Exchange (CBOE).

How do index options differ from individual stock options?

Underlying index of index options

The underlying index of index options represents a specific market or industry. For example, the S&P 500 index represents the 500 largest publicly traded companies in the United States. By trading index options, investors can gain exposure to the overall performance of the market or a specific sector without having to trade individual stocks.

Comparing index options and equity options

Equity options, also known as stock options, give investors the right to buy or sell individual stocks. This means that equity options are based on the value of a specific stock, while index options are based on the value of an underlying stock market index. Equity options are useful for investors who want to speculate on the price movement of a particular stock, while index options are more suitable for those who want to trade the broader market.

Benefits of trading index options

Trading index options can offer several benefits to investors. Firstly, they allow for diversification as they represent a basket of stocks rather than a single stock. Additionally, index options can provide protection against market downturns and can be used as a hedging tool to manage risk. Furthermore, trading index options can be more cost-effective compared to trading individual stocks, as it requires less capital.

What is the difference between call and put options for indexes?

Call options for stock market indexes

Call options for stock market indexes give the option holder the right to buy the underlying index at the strike price. If the index value increases above the strike price, the option holder can profit by exercising the option or selling it for a higher price. Call options can be used to speculate on an upward movement in the market or as a hedging tool against a short position.

Put options for stock market indexes

Put options for stock market indexes give the option holder the right to sell the underlying index at the strike price. If the index value decreases below the strike price, the option holder can profit by exercising the option or selling it for a higher price. Put options can be used to speculate on a downward movement in the market or as a hedging tool against a long position.

Settling index options in cash

Unlike equity options, index options are usually settled in cash rather than through the purchase or sale of the underlying index. This means that upon exercise or expiration of the option, the option holder receives the cash difference between the index value and the strike price, rather than the physical delivery of the underlying index. The reason index options are settled in cash rather than the underlying assets (stocks) is practical since the index ETFs represent hundreds of assets (stocks). 

Conclusion

Index options can be a valuable tool for investors looking to gain exposure to the broader market or specific sectors without having to trade individual stocks. They provide flexibility, diversification, and risk management opportunities. By understanding the differences between index options and stock options, learning different trading strategies, and managing risks, investors can effectively navigate the world of index options trading and potentially generate profits.

Summary Points

• Novice options traders often confuse options on cash indices like SPX with options on traded stocks (Apple – AAPL) or ETFs (SPY).
• For most traders and investors ETF Index Options provide more flexibility to trade with a much lower initial investment.  Options on Index Futures are designed for larger players like mutual funds and asset managers.  Recently, mini contracts have been offered to attract smaller investors or traders.  For most traders and inverstors, ETFs options are more popular.
• Index options on futures require more capital per contract compared to their ETF counterparts. Thus, most traders use ETFs. 
• Index options on futures are cash-settled, meaning they are settled in cash rather than by delivering the underlying shares.
• Index options on futures receive preferential tax treatment as “1256 contracts,” with 60% of profits taxed as long-term capital gains and 40% taxed as short-term capital gains.