What Is an Index Option?
Let me explain what an index option is directly to you: it's a financial derivative that grants you the right, but not the obligation, to buy or sell the value of an underlying index, like the S&P 500, at a specified exercise price. You won't be buying or selling actual stocks here. Often, these options use an index futures contract as the underlying asset.
These index options are always settled in cash and are typically European-style, which means they only settle on the maturity date with no option for early exercise.
Key Takeaways
Index options are contracts that base themselves on a benchmark index or a futures contract tied to that index as the underlying instrument. They're usually European-style and settle in cash based on the index value at expiration. Just like any options, they give you the right, but not the obligation, to go long with a call or short with a put on the index value at a preset strike price.
Understanding Index Options
You can use index call and put options as tools to trade the overall direction of an underlying index while risking only a small amount of capital. For index calls, your profit potential is unlimited, but the risk is capped at the premium you paid for the option.
With index puts, the risk is also limited to the premium, but the profit is capped at the index level minus the premium, since the index can't drop below zero.
Besides profiting from broad index movements, these options let you diversify your portfolio if you're not keen on investing directly in the index's underlying stocks. You can also hedge specific risks in your portfolio with them.
S&P 500 and VIX
In the U.S. market, the most active index options are on SPXW, which represents the S&P 500, and the VIX, the Cboe Volatility Index.
Keep in mind that while American-style options can be exercised anytime before expiry, index options are generally European-style and exercisable only on the expiration date.
Most index options don't track the index directly but use an index futures contract as the underlying security. So, an option on an S&P 500 futures contract is essentially a second derivative of the S&P 500 index, since the futures are derivatives themselves.
This setup introduces more variables, as both the option and the futures have their own expiration dates and risk-reward profiles. These contracts come with a multiplier that affects the overall premium—usually 100, but the S&P 500 has a 250x multiplier.
Example of an Index Option
Consider a hypothetical index called Index X, currently at a level of 500. Suppose you decide to buy a call option on Index X with a strike price of 505, priced at $11. The full contract would cost you $1,100, calculated as $11 times the 100 multiplier.
The underlying here isn't individual stocks but the cash level of the index adjusted by the multiplier—in this case, $50,000, or 500 times $100. Instead of putting $50,000 into the index stocks, you can buy the option for $1,100 and use the rest elsewhere.
Your risk in this trade is limited to that $1,100. The break-even point is the strike price plus the premium paid, so 505 plus 11 equals 516. Above 516, the trade profits.
If the index hits 530 at expiration, exercising the call would net you $2,500 in cash from the counterparty, or (530 minus 505) times $100. After subtracting the initial premium, that's a $1,400 profit.
What Are Index Options Strategies?
You have several common strategies for index options, including long call or long put positions, covered calls or protective puts, straddles, and strangles.
How Are Index Options Taxed?
Since traders rarely hold options longer than a year, these are typically taxed as short-term capital gains. However, broad-based index options follow the 60/40 rule: 60% of gains are treated as long-term, and 40% as short-term, no matter the holding period. This taxation gives them an edge over other options.
What Are You Actually Buying When You Trade Index Options?
When you trade an index option, you're buying the right to buy or sell a futures contract on the underlying index. As these futures are derivatives, the index option itself acts as a second derivative of the index.
The Bottom Line
Index options allow you to hedge your portfolio while gaining exposure to a wide market segment. As with other options, you need to grasp how expiration dates and strike prices influence their value. Unlike some options, these are typically cash-settled and can't be redeemed early.
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