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What is an index option?

Paul Beck


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The best way to explain index options is to start with a primer on market indices. An index is a numerical representation of the market as a whole, or a section of the market as a whole. In the same way a polling firm might call 1,000 people to get an idea of voter sentiment, an index is a statistical sampling of equities that represents the movement of the overall market. It is an imaginary portfolio; you cannot actually buy an index. This works well with options, since options are derivatives, which derive value from price movement, not ownership of an underlying asset. No securities are bought or sold, and the contract is settled in cash at expiry. Most index options are European-style contracts, as opposed to American-style, which means they settle on the expiration date; there is no risk of early exercise. Index options are priced differently than stock options. With an options contract for a security, the contract price is based on the premium for a lot of 100 shares of stock. The premium is tied to the intrinsic value of the underlying security and the time value of the contract. A longer time to expiration generally increases the time value of the option. The price of an index option contract is based on $1 of exposure for every point on the index, multiplied by 10 in the case of e-mini contracts, and by 100 in the case of standard contracts. In other words, if the S&P 500 is at 2,650, the notional value of an S&P 500 mini-contract would be $26,500 and a standard contract would be $265,000. The multipliers also apply to premium quotes. If the premium is for a standard contract, you multiply it by 100. Not all indices offer e-mini options contracts, but the premium for those that do is multiplied by 10. Here’s how to read an options quote table from the CBOE: The first column, “last,” indicates the last price at which an option was opened or closed. Net is the net change, bid and ask reflect the prices a buyer is willing to pay and a seller is willing to accept, and volume is the number of contracts traded that day. IV is implied volatility; a low IV suggests buying strategies such as calls, debit spreads, and long straddles. Higher IV should trigger selling strategies such as covered calls and credit spreads. Delta is the ratio comparing the change in the price of the option to the change in the underlying asset. A delta of 0.50 means that, for every 1-point move in the index, the option price will move 0.50. Gamma is a derivative of delta and helps gauge the option’s price movement relative to its being in or out of the money. Int is open interest, which reflects the number of currently open options contract. Unlike stocks, which have a fixed amount available to trade, new options contracts can be created at any time. High open interest indicates good liquidity. The final column shows the expiration date, symbol, and strike price. Index options are great for hedging a diversified portfolio. If you own several stocks on an index and you are worried that the market is showing signs of weakness, you could buy put options on each individual stock and shell out a bunch of cash on transaction fees, or you could buy a put option on the index. If your fears bear out and the market declines, you’ll make money off your options to offset the losses in your portfolio. In the U.S., index options get favorable tax treatment compared to index funds in that 60% of gains are taxed at the long-term capital gains tax rate even if the options were held less than a year. This can be a great advantage for traders looking to mitigate their tax exposure.
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