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Index Options 2021- What is index options trading
and how does it work?
fxreviews.best/blog/index-options-trading
What are Index Options? The financial market
offers traders a number of various options to
invest their capital and maximise profits.
Traders can invest capital in derivatives to
minimise the risks and have options of trade
other than the primary markets. One such
financial derivative is index options. These
indices are based on the stock that allows
traders to buy and sell the underlying index for
a specific time period. Investors choose the
index options from a pool of stocks of the index
to d iversify their portfolios and reduce the
risk. For example, Dow Jones Industrial Average,
SP500 and Nasdaq Composite etc. are some of the
famous stock indices of the trade market. Index
options are classified as European style rather
than the American style due to the exercise. As
these are settled in cash when exercised in
contrast to options of single stocks, the
underlying stock gets transferred when
exercised. Traders have several options to trade
in the indices, and to get into the details of
the topic, the article discusses what index
option is and how it works to profit traders? So,
lets drive in for more information on index
options trading.
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Index Options vs Stock Options Index options are
similar to the stock options as their price
increases and decreases because of several
factors. It may be the value of underlying
security, uncertainty, strike price, expiry time
period, dividends, interest rates, etc. However,
index options are different from stock options
trading. For a trading index, traders should have
a clear understanding of these two options and
how they differ from one another. Underlying
Stocks Stocks and index options are different on
the basis of their underlying stocks. The traded
stock in stock option is single it trades on a
single companys stock. At the same time, index
options trade on a large basket of stocks from
various companies. The index options represent
the broad and narrow band of the financial
market. In narrowly based indices, the stocks are
limited to a certain sector it may be a
financial industry or photonic with few
stocks. A broad based index option has several
financial industries incorporated, which are
represented by their components. However, there
are not tons of stocks in the broad based
index. For example, SP 500 and Dow Jones
Industrial averages are broad based index options
and SP 100 and Japans index options are good
examples of narrow based index
options. Settlement The settlement method of
both the index options are different, as stock
options have an agreement in which the
underlying stock is passed from one owner to
another, termed as changing hands. On the other
hand, index options are settled in cash and the
underlying stock is not passed on. Moreover,
the style of settlement is also contrasting, the
stock options prefer the American style
exercise, and the index options use the European
style exercise. In the American style exercise,
the underlying stock can be exercised during the
period at any point before the expiration date.
Whereas the European style exercises the
underlying stock by exercising them on the
expiry date. So, it is kept until the expiration
date. Although traders are not compelled to
exercise the index options till the expiry date,
they can buy and sell the stock and close their
trading position at any time. Settlement
Date The date of settlement of stock and index
options differs the stock options are settled on
the third Friday, with settlement being set on
Saturday. Index options are usually traded on
Thursday before the third Friday as the last
trading day. Index options are determined or
settled on Friday.
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The strike price and the settlement price are
then compared against the options to check on
the change. Trading Hours The trading hours of
both the options have some gap between them the
stock option and narrow index option are traded
till 0400 ET, whereas the broad based index
options are traded till 0415 ET. The stock
options and narrow based index options are
impacted by any news that comes after market
closure. In contrast, the broad based index
option has a wide range of companies, and there
is not much of an impact due to such a
reason. How do Index Options Trading work? As of
now, we have understood that index options and
stock options are different. But to better
understand index options trading, we need to get
into the depth of its trade. How index options
are traded, and how do these work? To get
answers to the questions, the paragraph talks
about index options. Index options trade no
actual stocks, but they trade underlying stock
indexes. The index options use future index
contracts as the underlying assets to trade. In
index options, there is no physical trade of the
underlying index, so the trade is settled in
cash. The index options are traded in European
style on the expiry date, and traders cannot
exercise the asset earlier than their expiration
date. A trader purchases the index through an
index call option, and with the put option trader
gets the right to sell the index option in the
financial market. These are low risk derivative
instruments that provide traders with the
advantage of the directional swings of the index.
Traders can enjoy unlimited profits through the
index call options, with downside loss narrowed
to the premium paid on the call options.
Whereas the index put options profit is perfect
when the index level is minus from the put
premium with downside limited to put
premium. The index options incur a limited loss
with more exposure to the stocks at a fraction
cost. Index options are generally in multiplier
form, determining the contract price, which is
usually 100 on most indices and
exchanges. Investors of the index options can
even lock their gains by purchasing put
option contracts on each index and lock their
sale price on each stock. The strategy works best
for small portfolios with protection from market
crashes. Although, it does not work in large
portfolios and diversification as it is not cost
effective to lock positions. For diversified
portfolios, traders can use hedging strategies
for the overall portfolio. Investors determine
the correct index used as a proxy for the
portfolio. After which, investors figure out the
number of index options for portfolio
hedge. Example of Index Option
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An investor purchases index call option of SP
500 with the following components Index spot
price 12000 Index call option premium 50
Contract multiplier 80 Contract cost 4000 (50
x 80) Strike price 12,500 Break Even point
12,650 (12,50050) SP 500 Index expiry
13,000 So, the investor would use the call
option that exceeds the strike price in addition
to the premium, which makes it a profitable
undertaking. Traders can determine profit
by subtracting contract costs from the gross
proceeds. Call proceeds 50,000 (13000 12500)
x 100 Profit of investor 46,000 ( 50,000
4000) Characteristics of Index Options Index
options have some specific characteristics that
make them different from all the derivatives. The
qualities of the index make index options
standalone in the derivatives of the financial
market. Investors, by knowing this, can take
maximum advantage of the index options in the
market. So, here are the characteristics of index
options European Style The first and most
prominent characteristic of index options is
their style of trading. In European style, the
trade is settled on the expiration and not before
that. Thus, traders have to wait till the
maturity of the index option contract. The style
makes it different from other options contracts
that operate on the American style like futures
and forward contracts. However, there are always
loopholes so that a few index options could
be traded in the American style. Expiration Index
options expiry date is mostly in a serial manner
which means that the index options mature in the
months of March, June, September and December.
However, there could be changes with some of the
index options depending upon the financial
instrument traded. Some index options mature
every month and could follow the serial manner as
well. Cash Settlement Index options are settled
in cash and not physically passed forward like
other options contracts. These are the European
style contracts that are settled in cash without
any physical delivery. In these contracts, the
cash payment is made after the expiry date of the
index options. Thus, investors can have
different dates for the settlement of the cash as
per their needs.
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Index Options Valuation Index option valuation
includes the following terms Strike price Days
to expiry Dividend The volatility of the stock
price Risk free rate The underlying index spot
price All the above mentioned terms are used in
the valuation of the index to have
depth knowledge of the index options trading.
Investors can use them to trade and analyse the
market for profitable investments. Index Options
Trading Strategies Index options have several
strategies that could be used to maximise
profits. A trader can plan and analyse the
market and the trading instrument to choose the
best strategy for the financial market. Below
listed are some of the major index options
strategies Speculation Speculation strategy is
used by most of the index and stock options
traders. They bet on the index of various
companies to earn from the increase and decrease
of the fluctuations. The strategy requires the
study of the market and the index before betting
as it bets on future changes, which could result
in profit or loss for the trader. The bullish
strategy of speculation traders buy the call
options and bull the call spreads. It looks for
a significant increase in the index to earn good
profits. Traders go for limited risk to hedge for
a short market position. In contrast, the bearish
strategy of speculation traders buy the put
options and bear the put spreads. In the
strategy, traders look for profit from the
significant decline of the index
traded. Income Income is the premium that
traders collect from the mild direction view of
the index. In this strategy, the bullish is used
where traders sell the bull put spreads. They
look for a profit from the rise in the level of
the index traded. On the other hand, the
bearish strategy of income sells the bear call
spreads, where traders look for a decline in the
index value. Hedging H edging strategy is the
most popular correction strategy that supports
the traders against risks and difficulties of
the trade. With the use of hedge, traders can
minimise their risks and earn profit. It has
catastrophic and comprehensive protection for the
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portfolio protection of the investors.
Catastrophic is cheaper insurance, in which
traders buy the put options for protection from
the major market decline. Comprehensive
protection is expensive insurance against
portfolio protection. In this, traders buy put
options and look for profit from a moderate
market decline in the level of the
index. Benefits of Index Options Trading Index
options have the following important and benefits
for the investors of the market Used by hedgers
and speculators for market exposure with single
transactions. Index option traders have limited
loss as per the premium paid for the index with
a total potential gain. Traders of index options
enjoy diversification benefits. Index options are
less erratic in comparison to individual stocks
that make the index. Traders have more
predictability in index options. Index options
are liquid due to their popularity in the
financial market. Traders of index options can
predetermine the risk. Conclusion Traders of
index options have a lot of options and benefits
with the trade of these derivatives. They can
easily invest, monitor and enter and exit the
market as per the requirements. However, traders
need market understanding and skills for the use
of the indices. There are several brokers
available in the market that offer indices for
trading. Investors can go with reputable brokers
such as R OInvesting and use the trading tools to
invest with indicators and analysis tools. This
would benefit the traders with market prediction
and high profits. Overall, index options trading
is a good source of investment that traders can
use as a derivative instrument to get good
returns with minimum risk involved.