What is Index Options Trading: A Complete Guide

Views 126Jul 8, 2024

Investors interested in trading options can choose from a range of options products, including equity options, bond options, index options, and more.

Index options have increased in popularity over the years. One of the many reasons that investors may trade them is because they offer an opportunity to trade based on a directional bias of the market, whether they're bearish, bullish or neutral. But there's more to know about index options. Read on to learn more.

What are index options?

An index option is a financial derivative contract that gives the holder the right, but not the obligation, to buy or sell an underlying stock market index at a specified price for a set time period. Index options are typically European-style options, which settle only at the expiration date; they are also cash settled.

How do index options work?

Index options provide investors with the ability to speculate on the performance of a broad market index or specific market sector, rather than individual stocks. These options derive their value from underlying indices including the S&P 500, NASDAQ-100, or Dow Jones Industrial Average. When trading index options, investors can cost-effectively gain exposure to the overall market or specific segments, which helps in potentially diversifying their investment portfolio with a single transaction.

Index options can be used for various investment strategies including hedging, speculating, or income generation. Hedging with index options can allow investors to protect their portfolios against potential market downturns by purchasing put options. Call options can be bought to speculate on anticipated market upswings and writing (selling) index options can generate income, though it comes with the potential obligation to settle if the decision moves against the seller.

Example of index options trading

An investor buys a call option on the S&P 500 index with a strike price of 4,020, which is 0.5% higher than the current trading price of 4,000. The contract has a multiplier of 100, so if the option is priced at $10, the investor would need to pay $1,000. The call option may profit if the index closes above the strike price on the expiration day.

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Options strategies for index options trading

There are many different strategies when trading index options, from beginner level, such as the long call and long put to more advanced strategies including strangles and straddles. Depending on an investor's experience, investment goals, and market sentiment, this can help them choose which strategy to use. Regardless of which one is selected, it's important to understand that options carry risks.

Long call

A long call index option trade is a strategy that gives the buyer the right, but not the obligation, to purchase an index at a set strike price before the expiration date. The buyer pays a premium for this right, but is not obligated to exercise the option. The goal is to profit from a short-term increase in the index's price.

Long put

A long put option index trade (also known as a put option), is a bearish strategy that gives the buyer the right to sell 100 shares of an underlying index at a predetermined price (strike price), on or before the expiration date. The buyer (option holder), pays a premium to acquire this right. Instead of buying put options for each individual stock, investors may buy put options on the stock index. This can limit portfolio loss, as the put option positions can gain value if the stock index declines.

Covered Call

A covered call strategy involves pairing a long position (owning the underlying security) with a short call option on the same security. For the long call option, you own a specific amount of an underlying asset (the index) and the short call option, you sell a call option on the same index. The combination of these two positions can lead to higher returns and lower volatility compared to just holding the underlying index.

Protective Put

A protective put index options strategy involves holding a long position in an index or an index-based portfolio while purchasing put options on the same index. This approach acts as a form of insurance, providing downside protection against significant losses in a declining market. The strategy can limit losses and establish a floor price, while still allowing for potentially unlimited upside.

When implementing a protective put strategy, an investor first acquires a portfolio that reflects a broad market index, such as the S&P 500. To hedge against potential declines, the investor then buys put options on that index. If the market value of the index drops below the put option's strike price, the investor can exercise the option, effectively selling the index position at the higher strike price. This maneuver helps to offset the losses in the portfolio, as the put option's value will increase while the index value decreases.

Straddle and Strangle

For a strangle, this involves selling a call with a higher strike price and a put with a lower strike price. For example, when the index is trading at 7300, an investor might sell an August 6700 Put at 77 and an August 2022 7700 Call at 33. If the index trades between 6700 and 7700 at expiration, both options expire worthless and the investor retains the maximum profit.

For a straddle, this strategy involves simultaneously purchasing or selling both a call option and a put open with the same strike price and expiration date for a particular underlying index. If the call and put are both purchased, the associated trade structure is called a “long straddle” but a "short straddle" occurs if the call and put are both sold. For example, a long straddle call with an index trading at 7300, an investor could buy an August 6700 call and sell an August 6700 put at 33.