An index option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying index at a strike price on an expiration date.
Index options give investors the opportunity to trade on entire markets or specific segments of a market with a single transaction. This article will explain everything there is to know about index options so that investors are able to incorporate this investment into their own portfolios.
An index is hypothetical portfolio of stocks representing a particular market or a segment in it. For example, the S&P 500 is an index that is comprised of the 500 largest U.S. publicly traded companies by market value. Therefore, the underlying asset for an index option is not one particular stock but rather is comprised of many stocks.
Index calls and puts are a low-risk way to profit on the directional move of an index. When buying an index call option, the potential profit is unlimited, while the risk is limited to the premium paid for the option. When buying an index put option, the potential profit is capped at the index level minus the premium paid, while the risk is limited to the premium paid for the option.
Index options are typically European-style options. This means that the option contract can only be exercised on the expiration date. This differs from American-style options which can be exercised anytime from the time of purchase until the expiration date.
Let’s look at an example of an investor buying an index option.
Assume the S&P 500 index is at a level of 2,000. An investor buys a call option for the S&P 500 index with a strike price of 2,010. With index options, the contract has a multiplier that determines the overall price. Usually, the multiplier is 100. If, for example, this index option is priced at $20, then the entire contract costs $2,000, or $20 times 100.
In this trade, $2,000 is the maximum amount the investor can lose. This risk is significantly lower than if he tried to invest in each company of the index individually. The lower risk is what makes index options appealing to investors.
The breakeven point in an index call option is the strike price plus the premium paid. In this example, the breakeven point would be 2,030, or 2,010 plus 20. Any level above 2,030 would be a profitable trade for the investor. If the index is at 2,035 at expiration, then the investor would exercise the call option and receive $2,500, or (2,035 – 2,010) x $100. After subtracting the premium, this trade would give the investor a total profit of $500, or $2,500 minus $2,000.
After looking at this example, investors can see how index options can be a way to diversify their portfolios while keeping the risks involved low. Index options are a useful tool to earn a profit off directional moves in certain indices.
