Index Option

An index option is a financial instrument that gives the right (but not the obligation) to trade with the value of a basic index at a specified strike price. Real shares are not bought or sold. An index option is often used as an index futures contract.

The European-type index options are only enforced on the maturity date, not earlier. They are always settled in cash.

Index Option understanding

The most widely used index options are call and put. They are used to deal with the general direction of the base index. For call and put index options, the risk is limited by the premium (small capital) paid for the option. The potential profit of a call is not limited, but the potential profit of a put is limited by the index level minus the paid premium (the index is not below zero).

Moreover, index options can be used for portfolio diversification (when a person doesn't want to invest in stocks that is the index basis), for hedging of portfolio specific risks. American options can be settled at any time before maturity, European (index) options can be settled only on the maturity date.

The futures contract serves as the base security for most index options, to not track the index directly. So, it turns out that futures are derivatives of the S&P 500 index, and the S&P 500 futures contract option is the second derivative of the S&P 500 index.

The option and futures contract have different maturity dates and risk/reward profiles. Because of this, more variables have to be considered. Such index options contractor has a multiplier to calculate the total premium or pay price. Normally, the multiplier value is 100, but the S&P 500 multiplier value is 250x.

Index Option example

Let's suppose we have an Index X. Currently its value is 500. Let's assume an investor has purchased a call option on Index X with a maturity price of 505. With a call option price of $505 at $11, the entire contract is priced at $1,100 ($11 x multiply by 100).

The money level of the index (not one stock or set of stocks) in multiples would be the basic asset of that contract ($50,000 = $500 x $100).  A person can invest in an option with a price of $1,100 avoiding $50,000 investment in an index stock. The remaining $48,900 can be used elsewhere.

The risk of this trade is limited by $1,100. When trading an index call option, the strike price plus the premium paid will be the breakeven point (516 = 505+11). Any value higher than 516 will turn a profit on this trade.

If the index level is 530 at maturity date, the call option holder will get $2,500 in cash (530 - 505) x $100). This trade will bring a profit of $1,400, taking into account the payment of the initial premium.