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Like equity options, index options offer the investor an opportunity to
either capitalize on an expected market move or to protect holdings in the underlying
instruments. The difference is that the underlying instruments are indexes. These
indexes can reflect the characteristics of either the broad equity market as
a whole or specific industry sectors within the marketplace.
Index options enable investors to gain exposure to the market as a whole or to
specific segments of the market with one trading decision and frequently with
one transaction. To obtain the same level of diversification using individual
stock issues or individual equity option classes, numerous decisions and transactions
would be required. Employing index options can defray both the costs and complexities
of doing so.
Unlike other investments where the risks may have no limit, index options offer
a known risk to buyers. An index option buyer absolutely cannot lose more than
the price of the option, the premium.
Index options can provide leverage. This means an index option buyer can pay
a relatively small premium for market exposure in relation to the contract value.
An investor can see large percentage gains from relatively small, favorable percentage
moves in the underlying index. If the index does not move as anticipated, the
buyer's risk is limited to the premium paid. However, because of this leverage,
a small adverse move in the market can result in a substantial or complete loss
of the buyer's premium. Writers of index options can bear substantially greater,
if not unlimited, risk.
An option holder is able to look to the system created by OCC's Rules and Bylaws
(which includes the brokers and Clearing Members involved in a particular option
transaction) and to certain funds held by OCC rather than to any particular option
writer for performance. Prior to the existence of option exchanges and OCC, an
option holder who wanted to exercise an option depended on the ethical and financial
integrity of the writer or his brokerage firm for performance. Furthermore, there
was no convenient means of closing out one's position prior to the expiration
of the contract.
OCC, as the common clearing entity for all exchange-traded option transactions,
resolves these difficulties. Once OCC is satisfied that there are matching orders
from a buyer and a seller, it severs the link between the parties. In effect,
OCC becomes the buyer to the seller and the seller to the buyer. As a result,
the seller can buy back the same option he has written, closing out the initial
transaction and terminating his obligation to deliver cash equal to the exercise
amount of the option to OCC. This will in no way affect the right of the original
buyer to sell, hold or exercise his option. All premium and settlement payments
are made to and paid by OCC.
A stock index is a compilation of several stock prices into a single number.
Indexes come in various shapes and sizes. Some are broad-based and measure moves
in broad, diverse markets. Others are narrow-based and measure more specific
industry sectors of the marketplace. Understand that it is not the number of
stocks that comprise the average that determine if an index is broad-based or
narrow-based, but rather the diversity of the underlying securities and their
market coverage. Different stock indexes can be calculated in different ways.
Accordingly, even where indexes are based on identical securities, they may measure
the relevant market differently because of differences in methods of calculation.
An index can be constructed so that weightings are biased toward the securities
of larger companies, a method of calculation known as capitalization-weighted.
In calculating the index value, the market price of each component security is
multiplied by the number of shares outstanding. This will allow a security's
size and capitalization to have a greater impact on the value of the index.
Another type of index is known as equal dollar-weighted and assumes an equal
number of shares of each component stock. This index is calculated by establishing
an aggregate market value for every component security of the index and then
determining the number of shares of each security by dividing this aggregate
market value by the current market price of the security. This method of calculation
does not give more weight to price changes of the more highly capitalized component
securities.
An index can also be a simple average: calculated by simply adding up the prices
of the securities in the index and dividing by the number of securities, disregarding
numbers of shares outstanding. Another type measures daily percentage movements
of prices by averaging the percentage price changes of all securities included
in the index.
Securities may be dropped from an index because of events such as mergers and
liquidations or because a particular security is no longer thought to be representative
of the types of stocks constituting the index. Securities may also be added to
an index from time to time. Adjustments to indexes might be made because of such
substitutions or due to the issuance of new stock by a component security. Such
adjustments and other similar changes are within the discretion of the publisher
of the index and will not ordinarily cause any adjustment in the terms of outstanding
index options. However, an adjustment panel has authority to make adjustments
if the publisher of the underlying index makes a change in the index's composition
or method of calculation that, in the panel's determination, may cause significant
discontinuity in the index level.
Finally, an equity index will be accurate only to the extent that:
- the component securities in the index are being traded
- the prices of these securities are being promptly reported
- the market prices of these securities, as measured by the index, reflect
price movements in the relevant markets.
An equity index option is an option whose underlying instrument is intangible – an
equity index. The market value of an index put and call tends to
rise and fall in relation to the underlying index. The price of an index call
will generally increase as the level of its underlying index increases, and its
purchaser has unlimited profit potential tied to the strength of these increases.
The price of an index put will generally increase as the level of its underlying
index decreases, and its purchaser has substantial profit potential tied to the
strength of these decreases.
Generally, the factors that affect the price of an index option are the same
as those affecting the price of an equity option: value of the underlying instrument
(an index in this case), strike price, volatility, time until expiration, interest
rates and dividends paid by the component securities.
The underlying instrument of an equity option is a number of shares of a specific
stock, usually 100 shares. Cash-settled index options do not relate to a particular
number of shares. Rather, the underlying instrument of an index option is usually
the value of the underlying index of stocks times a multiplier, which is generally
U.S. $100.
Indexes, by their nature, are less volatile than their individual
component stocks. The up and down movements of component stock prices
tend to cancel one another out, lessening the volatility of the index
as a whole. However, the volatility of an index can be influenced by
factors more general than can affect individual equities. These can range
from investors' expectations of changes in inflation, unemployment, interest
rates or other economic indicators issued by the government and political
for military situations.
As with an equity option, an index option buyer's risk is limited
to the amount of the premium paid for the option. The premium received
and kept by the index option writer is the maximum profit a writer can
realize from the sale of the option. However, the loss potential from
writing an uncovered index option is generally unlimited. Any investor
considering writing index options should recognize that there are significant
risks involved.
The differences between equity and index options occur primarily
in the underlying instrument and the method of settlement. Generally,
when an index option is exercised by its holder, and when an index option
writer is assigned, cash changes hands. Only a representative amount
of cash changes hands from the investor who is assigned on a written
contract to the investor who exercises his purchased contract. This is
known as cash settlement.
Purchasing an index option does not give the investor the right to
purchase or sell all of the stocks that are contained in the underlying
index. Because an index is simply an intangible, representative number,
you might view the purchase of an index option as buying a value that
changes over time as market sentiment and prices fluctuate. An investor
purchasing an index option obtains certain rights per the terms of the
contract. In general, this includes the right to demand and receive a
specified amount of cash from the writer of a contract with the same
terms.
Available strike prices, expiration months and the last trading day
can vary with each index option class, a term for all option contracts
of the same type (call or put) and style (American, European or Capped)
that cover the same underlying index. To determine the contract terms
for the option class(es) you wish to employ, please contact either the
exchange where the option is traded or The Options Industry Council.
The strike price, or exercise price, of a cash-settled option is the basis for
determining the amount of cash, if any, that the option holder is entitled to
receive upon exercise. See Exercise Settlement for further
explanation.
An index call option
is in-the-money when
its strike price is less
than the reported level
of the underlying index.
It is at-the-money when
its strike price is the
same as the level of
that index and out-of-the-money
when its strike price
is greater than that
level.
An index put option is in-the-money when its strike price is greater than the
reported level of the underlying index. It is at-the-money when its strike price
is the same as the level of that index and out-of-the-money when its strike price
is less than that level.
Premiums for index options are quoted like those for equity options,
in dollars and decimal amounts. An index option buyer will generally
pay a total of the quoted premium amount multiplied by $100 for the contract.
The writer, on the other hand, will receive and keep this amount.
The amount by which an index option is in-the-money is called its intrinsic value.
Any amount of premium in excess of intrinsic value is called an option’s
time value. As with equity options, time value is affected by changes in volatility,
time until expiration, interest rates and dividend amounts paid by the component
securities of the underlying index.
The exercise settlement value is an index value used to calculate
how much money will change hands, the exercise settlement amount, when
a given index option is exercised, either before or at expiration. The
value of every index underlying an option, including the exercise settlement
value, is the value of the index as determined by the reporting authority
designated by the market where the option is traded. Unless OCC directs
otherwise, the value determined by the reporting authority is conclusively
presumed to be accurate and deemed to be final for the purpose of calculating
the exercise settlement amount.
In order to ensure that an index option is exercised on a particular day before
expiration, the holder must notify his brokerage firm before the firm’s
exercise cut-off time for accepting exercise instructions on that day. On expiration
days, the cut-off time for exercise may be different from that for an early exercise
(before expiration). Note: Different firms may have different cut-off times for
accepting exercise instructions from customers, and those cut-off times may be
different for different classes of options. In addition, the cut-off times for
index options may be different from those for equity options.
Upon receipt of an exercise notice, OCC will assign it to one or more Clearing
Members with short positions in the same series in accordance with its established
procedures. The Clearing Member will, in turn, assign one or more of its customers,
either randomly or on a first-in first-out basis, who hold short positions in
that series. Upon assignment of the exercise notice, the writer of the index
option has the obligation to pay this amount of cash. Settlement and the resulting
transfer of cash generally occur on the next business day after exercise.
Note: Most firms require their customers to notify the firm of
the customer’s intention to exercise at expiration, even if an option
is in-the-money. You should ask your firm to thoroughly explain its exercise
procedures, including any deadline your firm may have for exercise instructions
on the last trading day before expiration.
The exercise settlement values of equity index options are determined by their
reporting authorities in a variety of ways. The two most common are:
PM settlement – Exercise settlement values are based on the reported level
of the index calculated with the last reported prices of the index’s component
stocks at the close of market hours on the day of exercise.
AM settlement – Exercise settlement values are based on the reported level
of the index calculated with the opening prices of the index’s component
stocks on the day of exercise.
If a particular component security does not open for trading on the day the exercise
settlement value is determined, the last reported price of that security is used.
Investors should be aware that the exercise settlement value of an index option
that is derived from the opening prices of the component securities may not be
reported for several hours following the opening of trading in those securities.
A number of updated index levels may be reported at and after the opening before
the exercise settlement value is reported. There could be a substantial divergence
between those reported index levels and the reported exercise settlement value.
Although equity option contracts generally have only American-style
expirations, index options can have either American- or European-style.
In the case of an American-style option, the holder of the option has the right
to exercise it on or at any time before its expiration date. Otherwise, the option
will expire worthless and cease to exist as a financial instrument. It follows
that the writer of an American-style option can be assigned at any time, either
when or before the option expires, although early assignment is not always predictable.
A European-style option is one that can only be exercised during a specified
period of time prior to its expiration. This period may vary with different classes
of index options. Likewise, the writer of a European-style option can be assigned
only during this exercise period.
The amount of cash received upon exercise of an index option or when
it expires depends on the closing value of the underlying index in comparison
to the strike price of the index option. The amount of cash changing
hands is called the exercise settlement amount. This amount is calculated
as the dif-ference between the strike price of the option and the level
of the underlying index reported as its exercise settlement value, in
other words, the option’s intrinsic value, and is generally multiplied
by $100. This calculation applies whether the option is exercised before
or at its expiration.
In the case of a call, if the underlying index value is above the strike price,
the holder may exercise the option and receive the exercise settlement amount.
For example, with the settlement value of the index reported as 79.55, the holder
of a long call contract with a 78 strike price would exercise and receive $155
[(79.55 – 78) x $100 = $155]. The writer of the option would pay the holder
this cash amount.
In the case of a put, if the underlying index value is below the strike price,
the holder may exercise the option and receive the exercise settlement amount.
For example, with the settlement value of the index reported as 74.88 the holder
of a long put contract with a 78 strike price would exercise and receive $312
[(78 – 74.88) x $100 = $312]. The writer of the option would pay the holder
this cash amount.
As with equity options, an index option writer wishing to close out
his position buys a contract with the same terms in the marketplace.
In order to avoid assignment and its inherent obligations, the option
writer must buy this contract before the close of the market on any given
day to avoid notification of assignment on the next business day. To
close out a long position, the purchaser of an index option can either
sell the contract in the marketplace or exercise it if profitable to
do so.
The versatility of index options stems from the variety of strategies available
to the investor. The most basic uses of index options are explained in the following
examples. These examples are based on hypothetical situations and should only
be considered as examples of potential trading approaches. Other strategies that
might be used with equity
options, such as spreads and straddles, can be employed with index options. For
more detailed explanations, contact your brokerage firm or the exchanges where
index options are traded.
Note: For purposes of illustration, commission and transaction costs,
tax considerations and the costs involved in margin accounts have been omitted
from the examples in this booklet. These factors will affect a strategy’s
potential outcome, so always check with your brokerage firm and tax advisor
before entering into any of these strategies. For
illustrative purposes, the index option positions in all of the following examples
are shown to be held until expiration. The premiums are intended to be reasonable,
but in reality will not necessarily exist at or prior to expiration for a similar
option.
Market Outlook: Bullish over the short term
Goal: Positioning to profit from an increase in the level of the underlying
index
You are anticipating an advance in the broad market or market sector measured
by the underlying index in the near future. You want to take an aggressive position
that can provide a great deal of leverage. This decision is made with the understanding
that there is a possibility you may lose the entire premium you pay for the option.
An index call option gives the purchaser the right to participate in underlying
index gains above a predetermined strike price until the option expires. The
purchaser of an index call option has unlimited profit potential tied to the
strength of advances in the underlying index.
Scenario
Assume the underlying index that interests you is symbolized as XYZ and is currently
at a level of 200. You decide to purchase a 6-month XYZ 205 call for a quoted
price of $4.75 per contract. Your net cost for this call is $475 ($4.75 x 100
multiplier). You are risking $475 if the underlying index level is
not above the strike price of 205 when the XYZ call expires. The break-even point
(BEP) at expiration is an XYZ index level of 209.75 (strike price 205 + premium
paid $4.75) because the call will be worth its intrinsic value of $4.75, which
is what you originally paid for it. The higher the XYZ index settlement value
is above the break-even point at expiration, the greater your profit.
Possible Outcomes at Expiration
1. XYZ index level above the break-even point (209.75):
If at expiration XYZ index has advanced to 215, the XYZ 205 call will be worth
its intrinsic value of $10 (settlement value 215 – strike price 205). Your
net profit in this case would be $525 (settlement amount $1000 received from
exercise – net cost of
call $475).
Buy XYZ Index 205 Call at $4.75 with Index at 200
Net Cost for Call = $475
Level of XYZ Index at
expiration |
XYZ Index Declines to 198 (below
strike) |
XYZ IndexAdvances to 207 (between
strike and BEP) |
XYZ Index Advances to 215 (above
BEP) |
| Move in level of index |
up 2 pts. |
up 7 pts. |
up 15 pts. |
Value of call at expiration
(per contract) |
0
(out-of-the-money) |
$2 |
$10 |
| Less premium paid for call |
$4.75 |
$4.75 |
$4.75 |
Net profit/loss*
(per contract x 100) |
�$475 |
�$275 |
$525 |
*Exclusive of commissions, transaction costs and taxes.
2. XYZ index level between strike price (205) and break-even
point (209.75):
If at expiration XYZ index has advanced to 207, the XYZ 205 call
will be worth its intrinsic value of $2.00 (settlement value 207 – strike
price 205). You could exercise the option and receive the settlement
amount of $200 ($2.00 intrinsic value x
100 multiplier). This amount would be less than the net amount paid for the call
($475), but it would offset some of that cost. The net loss in this case would
be $275 (net cost of call
$475 – settlement amount $200 received from exercise). This loss represents
a little more than half of your initial investment.
3. XYZ index level below strike price (205): If at expiration XYZ index
has declined to 198, the call would have no value because it is out-of-the-money.
You will have lost all of your initial investment, a net of $475. The net premium
paid for an
index option represents the maximum loss for an option purchaser. Note: No matter
how far XYZ declines below the strike price, the loss will not exceed $475.
Market Outlook: Bearish over the short term
Goal: Positioning to profit from a decrease in the level of the underlying
index
You are anticipating a decline in the broad market or market sector measured
by the underlying index in the near future. You want to take an aggressive position
that can provide a great deal of leverage.
This decision is made with the understanding that there is a possibility you
may lose the entire premium you pay for the option.
An index put option gives the purchaser the right to participate in underlying
index declines below a predetermined strike price until the option expires. The
purchaser of an index put option has substantial profit potential tied to the
degree of declines in the underlying index.
Scenario
Assume the underlying index that interests you is symbolized
as XYZ and is currently at a level of 200. You decide to purchase
a 6-month XYZ 195 put for a quoted price of $3.90 per contract. Your
net cost for this call is $390 ($3.90 x 100 multiplier). You are
risking $390 if the underlying index level is not below the strike
price of 195 when the XYZ put expires. The break-even point (BEP)
at
expiration is an XYZ index level of 191.10 (strike price 195–premium paid
$3.90) because the put will be worth its intrinsic value of $3.90, which is what
you originally paid for it. The lower the XYZ index settlement value is below
the break-even point at expiration, the greater your profit.
Possible Outcomes at Expiration
1. XYZ index level below the break-even point (191.10):
If at expiration XYZ index has declined to 185, the XYZ 195 put will be worth
its intrinsic value of $10 (strike price 195 – settlement value 185). Your
net profit in this case would be $610 (settlement amount $1000 received from
exercise – net cost of put $390).
2. XYZ index level between strike price (195) and break-even
point (191.10):
If at expiration XYZ index has declined to 193, the XYZ 195 put will be worth
its intrinsic value of $2.00 (strike price 195 – settlement value 193).
You could exercise the option and receive the settlement amount of $200 ($2.00
intrinsic value x 100 multi-plier). This amount would be less than the net amount
paid for the put ($390), but it would offset some of that cost. The net loss
in this case would be
$190 (net cost of put $390 – settlement amount $200 received from exercise).
This loss represents a little less than half of your initial investment.
3. XYZ index level above strike price (195): If at expiration
XYZ index has advanced to 202, the put would have no value because
it is out-of-the-money. You will have lost all of your initial investment,
a net of $390. The net premium paid for an index option represents
the maximum loss for
an option purchaser. Note: No matter how far XYZ advances above the strike price,
the loss will not
exceed $390.
Buy XYZ Index 195 Put at $3.90 with Index at 200
Net Cost for Put = $390
| Level of XYZ Index at expiration |
XYZ Index Advances to 202
(above strike) |
XYZ IndexAdvances to 193 (between strike
and BEP) |
XYZ Index Advances to 185 (above BEP) |
| Move in level of index |
up 2 pts. |
up 7 pts. |
up 15 pts. |
Value of call at expiration
(per contract) |
0
(out-of-the-money) |
$2 |
$10 |
| Less premium paid for put |
$3.90 |
$3.90 |
$3.90 |
Net profit/loss*
(per contract x 100) |
�$390 |
�$190 |
$610 |
*Exclusive of commissions, transaction costs and taxes.
For a more in-depth discussion of options pricing please take Interactive
Education Classes provided by OIC.
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