Index Options – What is index options trading and how does it work?

Index Options - What is index options trading and how does it work (1)

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Index options are a derivative instrument that traders of the market invest in for generating income. Traders invest in the financial instrument based on stock indices to buy the underlying stock index. These are for a certain period of time and give traders an opportunity to diversify their portfolios. Traded-in European style index options are a good choice in the financial markets. 

Moreover, the index options are cash settled thus, providing high liquidity for the market traders. These are taken from the large basket of stocks; traders can invest as per their choice and earn profits. The index options are used for various purposes, such as for hedging or speculation on the stocks. 

But, to understand the topic in-depth, traders should start with the base, so we’ll be discussing the index first and then proceed further to the features and functioning of index options. Let’s get into the index options and enhance our knowledge of financial markets. 

What is an Index?

The index has been part of mathematics since its inception, but its use in the financial markets is relatable to its basic use. The index is the method that is used by traders to analyze the performance of the group of stocks or securities in a particular manner. Mostly, using a standardized method for getting a perfect performance. 

The index performance is measured in groups that replicate the specific market part. Thus, the index could be of various types, such as the broad-based index, which covers the entire financial market or the index that is for a particular area or category. Some famous indexes are Dow Jones Industrial Average( DJIA) and Standard & Poor’s 500(S&P 500). 

Using the methodology and metrics, the index measures the price performance of the securities to be traded. It evaluates the performance of the securities against the market securities, and Traders prefer investing in the index as it is a low-cost way of investing. 

Traders can use the index to measure various aspects of the financial markets such as the interest rates, manufacturing outputs and inflation etc. A useful source for measuring the performance of the returns on the portfolio investments. The index serves as the tool and indicator of measurement of the statistics of the traded instrument of the market. 

The index uses various methodologies depending on the security or stock traded, and thus traders should be aware of the requirements of the index to have correct calculations. 

Index Options

Index options are derivative products that give traders the right to buy and sell the underlying security at a certain price or predetermined price. The traders invest in the underlying security such as NDX 100, DJX and S&P 500 etc. It has a basket of various stocks with a defined set of stocks with relatable weight and value of the calculated index. The indexes have their own lot size, expiry dates and multiple strike prices. 

Index options are similar to the futures contracts and forward contracts, which are set on an expiry date of the contract. Traders pay a premium on the index options and need not pay the full price of the contract to buy the options. The premium of the indexes is calculated on the basis of options calculators and the actual index values. 

Traders invest in derivative products such as index options to minimise their risks and maximise the profits. Using the European style of trading, in this style, the index option can only be exercised on the expiration of the contract. While there is another trading style, called the American style, in which traders can execute the options anytime in between the expiry time period. 

These are flexible trade options that provide the traders with hedging and speculations on the future of the index. Investors of index options have various strategies available in the market, and the simplest of the strategie is the call and put option. In this, investors buy on a call and put on the index. Traders buy a call option when they bet on the index level moving upwards, and the opposite happens when the index goes down, and the investor buys the put option. 

Similarly, traders can go call and put spreads. By using such strategies, traders can analyse the limited profits that they can be earned on the indexes. 

Traders can also go for the selling covered calls strategy, where the traders buy the underlying contract on the stock index and then sell the call options on the contract to earn profits. For using this strategy, traders have to understand it as it is an advanced strategy. In this, traders have to know about the position delta between the underlying asset and sold options. This helps traders to analyze the risks of the trade-in advance. 

Key Aspects of Index Options

Index options have some key areas that should be considered for trading the index options. The paragraph below discusses these points to better understand the traders and investors of the financial markets. 

Leverage and Risks

Index options traders get the leverage for trading similar to the market’s equity and other trade options. Traders can use the leverage as the premium paid on the index is small. To enjoy good benefits on their investments, traders go for leverage, as they want to earn large profits from the position held in the market. Moreover, traders can predetermine the risks of the trade due to the fact that traders can only lose the premium paid on the index options held in the market. 

Contract Multiplier

The index option traders investing in stocks have the option of contract multiplier of $100. Traders use the contract multiplier for computing the cash value of index options. 

Premium 

Premium is paid on the index options, similar to the equity options, which are quoted in dollars or cents. Traders can find out the price of the premium on the index options by multiplying the quoted premium price with the contract multiplier. The amount that comes is the amount that the buyer will have to pay for purchasing the index options and the amount that the trader will receive back on selling the index option. 

Rights

Index options holders do not possess the right to buy or sell the option as these are cash settled options. But, they have the right to demand cash value from the option writer on exercising the option. 

How do Index options work?

We have understood what index and index options are? So, the next step is to know how they work to be profitable for traders. Trading of the index is simple like other trading instruments; however, these are traded on underlying securities. Using the future index options as the contract to trade. The trade is in cash and involves no physical trade. 

The index options are derivatives that use the European style for trading, in which the contract is exercised on the expiry date only. Traders cannot exercise the trade before the expiry date that is decided by the investor. Traders purchase the index option using the index call option, and the put option gives them the right to sell the index options in the market. 

The risk in the index options is analysed in advance, and thus traders have to face low risk instruments. Therefore, traders can enjoy the directional swings advantage of the index. The premium is the only risk traders have to pay; thus, predetermined risks make it more straightforward. Traders can calculate the index options profit by deducting the index level from the put premium and downside limited to the put premium. 

Therefore, traders get more exposure to the market and less risks or limited losses. Traders can even have the benefit of fractions of stocks to trade in the market. Being the multiplier form, index options help traders determine the contract price, usually 100 on most exchanges. 

In addition, traders have the advantage of locking their profits in the market. Traders can do this by purchasing the put options on the index and lock the sale price of the stocks. It is a profitable strategy that works best with small portfolios and protects them from market crashes. But, it is a wrong choice in large portfolios and diversifications. 

Example of Index Options

For example, a trader purchases the index options of NDX 100 having following details: 

  • Index spot price: 15000
  • Index call option premium: $80
  • Contract multiplier: 120
  • Contract cost: $9600 ($80 X 120)
  • Strike price: 15,500
  • Break even point: 15,580 (15,500+$80) 
  • NDX 100 Index expiry: 16000

With these details, traders would get the profitable underlying asset to invest. Thus, traders can determine the profit minus contract cost from the gross proceeds. 

Call proceeds: $50,000 {(16000 – 15,500) x 100}

Profit: $40,400 ($50,000 – $9600)

Index Options Trading Starategies

Index options trading uses several trading strategies, but we have realised that speculation and hedging are the two most popular ones. Here, we’ll understand the strategies that work best with the index options and make them more profitable for traders and investors. 

Speculation

It is one of the most used strategies of the financial markets; in this strategy, the investors bet on the price of the index of the various companies. Traders earn from the increase and decrease in the value of the index. The fluctuations of the market play a big role in the speculation strategy. However, traders have to study the market and index before investing. As the bet on the index depends on the future changes in the market, it could be a profit or loss for the traders. 

In a bullish strategy of speculation, traders purchase the call options and bull the call spreads. Traders here look for an increase in the index to earn profits. In contrast, a bearish strategy buys the put options and bears the put spreads. Traders earn from the decline in the index traded. 

Income

Premium on the index options is the income that traders earn. Bullish is used when the traders sell the bull put spreads, and the traders look for profits from the increase in the index traded. Whereas, in bearish, the trader sells the bear call spreads and earns from the decline in the index options value. 

Hedging

Hedging is a correction strategy of index options that help traders to minimise the risks of the trade. It helps traders protect their portfolios and is a kind of cheap insurance that would aid traders from difficulties. 

Traders have two types of insurance, catastrophic and comprehensive protections. Catastrophic is cheap protection in which traders buy the put options for protection from the decline in the market. On the other hand, comprehensive is an expensive protection where traders buy the put options and earn from the moderate decline in the market. 

Advantages of Index Options

Index options have the following advantages for the traders and investors of the market: 

  • Market exposure 
  • Hedging 
  • Speculations 
  • Limited loss 
  • Diversification 
  • Less erratic 
  • Predictable 
  • Liquid 
  • Predetermined risks 

Disadvantages of Index Options

We have listed disadvantages of index options for a clear perspective of the derivative product: 

  • Higher spreads 
  • Lesser information 
  • Not available for all stocks 
  • Time decay 
  • Higher commissions 
  • Complicate for beginners 

Conclusion

Index options are beneficial trade options for investors and traders. They can invest easily, enter and exit the market, speculate and hedge over the instruments with a premium paid. Thus, making it a feasible option for the market players. However, the traders of index options need good market understanding and skills for better results. 

Traders can invest in the index option with the help of several online brokers such as Capixal and Brokereo. They have the best services with the required trading tools and platforms to assist traders. Thus, traders can maximise their profits with the use of the indicators and tools of the trading platforms by getting a trading account with the brokers. 

Index options are a good investment option that would be profitable for traders with the help of brokers. Overall, a protected and beneficial trade derivative for the investors and traders of the market. 

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