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Definition of Index Options

The term “index options” (IO) refers to the financial derivatives that give the derivative holder the right to purchase or sell the value of the underlying index at a pre-decided strike price. The transaction is purely based on the value of the index, and it doesn’t involve the purchase or sale of any actual stocks. Cash settlements are made for (IO); most of these options are European-style, meaning they can only be settled on their expiry date.

Explanation

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How Does Index Options Work?

In the case of the most basic options trading, i.e. call and put options, (IO) limits the risk of loss to the level of the premium paid for it. On the other hand, investors cap the profit potential for index put options at the index level minus the premium paid. At the same time, they enjoy unlimited profit potential with index call options. Moreover, investors also utilize (IO) to earn profits from movements in the index level, diversify investment portfolios without making direct investments in the underlying stocks, and hedge portfolio risks.

Example

Let us take the example of a hypothetical index currently trading at 1,000. Let us also assume that an investor purchased an index call option with a strike price 1,010. The contract has a multiplier of 100 that determines its overall price. The index call option is priced at $15, so the entire contract price is $1,500 (= $15 x 100).

Types of Index Options

Primarily, the (IO) varies based on the underlying index, such as DAX 30, Nikkei 225, S&P 500, etc., in which the investor gains the right to purchase or sell a certain number of units at a pre-determined price. (IO) They may also be differentiated based on the specific sector they focus on, e.g., industries like healthcare, banking, IT, etc.

Index Options List

The list below captures the symbol, description, and country of some of the most commonly traded (IO).

Symbol

Index description

Country

DAX DAX 30 Germany

HSI Hang Seng Hong Kong

N225 Nikkei 225 Japan

KOSPI KOSPI 200 Korea

FTSE FTSE 100 UK

SPX S&P 500 USA

NDX NASDAQ 100 USA

OEX S&P 100 USA

Index Options Strategies

Buy index call or put options: The investors can buy index call options to earn a profit if they expect the market to go up or buy index put options if they expect it to go down.

Sell covered calls: Investors purchase the underlying stocks for the index and sell index call options. They can profit from the call options premium if the index goes down or from the underlying stocks if it goes up.

Index Options Symbols

The symbols below are statistical values investors use to overview the index (IO).

Δ (Delta): It measures the relationship between the option price and the underlying index.

γ (Gamma): It measures the delta sensitivity per unit change in the underlying index.

λ (Lambda): It measures the % change in the option’s value for a 1% change in the underlying index value.

ρ (Rho): It measures the % change in the option’s value for a 1% change in the interest rate.

θ (Theta): It measures the sensitivity of the value of the option value for a unit change (7 days) in time.

κ (Kappa): It measures the % change in the option’s value for a 1% change in its volatility.

Advantages

Constructing them based on a large basket of stocks makes index options (IO) one of the best diversification alternatives available to investors.

Predicting the value of index options is easier as they are invariably less volatile.

The bid-ask spread of (IO) is rational, and the prices are close to their fair value most of the time as they are usually traded in high volumes, given their popularity among the traders.

The settlement of (IO) is much easier as they are settled in cash compared to the delivery of stocks in the case of other options.

Purchasing it involves a relatively lower investment than purchasing individual stock options.

Index options trading offers limited upside; hence, it does not attract investors seeking higher returns in exchange for higher risks.

The pricing model used for (IO) is very complicated.

Conclusion

So, it can be seen that investors use index options for various investment purposes, such as hedging portfolio risk, speculating future index movement, etc. Investors implement different strategies that minimize the risk to a large extent, but it comes in exchange for limited returns.