What does an index option mean?

An index option is a derivative financial instrument that lets the user choose whether to buy or sell the value of an underlying index, like the S&P 500 index, at a specific price. No real stocks are being bought or sold. A lot of the time, an index option will be based on an index futures contract.

Index options are always paid in cash; European-style options usually settle only on the date they mature and can’t be exercised early.

How to Understand an Index Option

With index call and put options, you can trade the general direction of an underlying index with almost no risk to your cash. With index call options, you can make as much money as you want, but the most you can lose is the price you paid for the option. If you buy an index put option, your risk is also limited to the premium you paid. However, your possible reward is limited to the index level minus the premium you paid, since the index can never drop below zero.

Index options can be used to diversify a portfolio when an investor doesn’t want to invest directly in the stocks that make up the index. They can also be used to profit from changes in the index. You can also use index options to protect your investments against certain risks. American-style options can be exercised at any time before they expire. On the other hand, European-style options can only be exercised on the date they expire.

Instead of directly following an index, most index options use an index futures contract as their base security. So, since S&P 500 futures are derivatives of the index, an option on an S&P 500 futures contract can be considered a second derivative of the index.

Because of this, there are more factors to consider because both the option and the futures contract have end dates and different risk/reward ratios. A ratio in the contract sets the overall premium, or price paid, for these index options. The ratio is 100 most of the time. What about the S&P 500? It has a 250x increase.

Example of an Index Option

Let’s make up an imaginary index called Index X. Its current number is 500. Suppose a person wants to buy a call option on Index X with a strike price of 505. If this 505 call option is worth $11, the whole deal costs $1,100, which is $11 times 100.

It is essential to remember that this contract’s underlying asset is not a single stock or group of stocks but the cash amount of the index as changed by the multiplier. It’s $50,000 in this case, which is 500 times $100. An investor can buy the option for $1,100 instead of putting $50,000 into the stocks in the index and use the extra $48,900 for something else.

The most that can go wrong with this deal is $1,100. The target price plus the premium paid is when an index call option trade breaks even. In this case, that’s 516, which is 505 plus 11. If the price goes above $516, this trade will make money.

The owner of this call option would be able to exercise it if the index level at closing is 530. They would then get $2,500 cash from the other trade side (530 minus 505) x $100. After taking out the original premium, this trade makes a profit of $1,400.

Conclusion

• Index options are options contracts that are based on a standard index. Or a futures contract that is based on that index.
• Most index options are European style, and when they expire, they settle in cash for the value of the index.
• Index options, like all other options, give the customer a choice. But not the duty—to either buy or sell the value of the index at a specific strike price. This is called “long” or “short.”