Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
Table of Contents
While stock options derive their value from the performance of a single stock, index options are derivatives of an index containing multiple securities. Indexes can have a narrow focus on a specific market sector, or may track a broader mix of equities. They’re listed on option exchanges and regulated by the Securities and Exchange Commission (SEC) in the U.S.
Like stock options, the prices of index options fluctuate according to factors like the value of the underlying securities, volatility, time left until expiration, strike price, and interest rates. Unlike stock options, which are typically American-style and settled with the physical delivery of stocks, index options are typically European-style and settled in cash.
Key Points
• Index options are derivatives based on market indexes, typically cash-settled and European-style.
• Index options are typically cash-settled and can only be exercised at expiration, unlike stock options which are often exercised early and settled with shares.
• Authorization from a brokerage is required to trade index options, and understanding risks is crucial.
• Index options offer broad market exposure, with trading hours and settlement methods differing from stock options.
• Trading levels range from simple covered calls and protective puts to high-risk naked options, each with specific requirements.
What Is An Index Call Option?
An index call option is a financial derivative that reflects a bullish view on the underlying index. They provide the buyer the right to receive cash if the index rises above the strike price on expiration. An investor who buys an index call option typically believes that the index will rise in value. If the index increases in value, the call option’s premium may also increase before expiration.
Before trading index options, it may be a good idea to make sure you have a solid understanding of what it means to trade options in a broader sense. It can be a complex, technical segment of the financial market.
đź’ˇ Quick Tip: In order to profit from purchasing a stock, the price has to rise. But an options account offers more flexibility, and an options trader might gain if the price rises or falls. This is a high-risk strategy, and investors can lose money if the trade moves in the wrong direction.
What Is An Index Put Option?
An index put option is a contract that reflects a bearish outlook. An investor who buys this derivative typically expects that its underlying index will decline in value during the life of the contract.
Differences Between Index Options and Stock Options
In addition to the fact that index options are based on the value of an underlying index as opposed to a stock, there are several other key differences between trading index options and stock options.
Trading Hours
Broad-based index options typically stop trading at 4:15pm ET during regular trading hours, with certain contracts on indexes eligible to continue trading from 4:15pm to 5:00pm ET. Some index options offer global trading hours from 8:15am-9:15am ET the following day.
When significant news drops after the market closes, it may affect the prices of narrow-based index options and stock options. Broad-based indexes may be less likely to be affected, as they typically reflect a more diversified mix of sectors within the index.
Recommended: When Is the Stock Market Closed?
Settlement Date and Style
While stock options use the American-style of exercise, which allows holders to exercise at any point leading up to expiration, most index options have European-style exercise, which allows exercise only at expiration (with some exceptions). That means the trader can’t exercise the index option until the expiration date. However, traders can still close out their index option positions by buying or selling them throughout the life of the contract.
As for settlement date, most stock index options usually stop trading on the Thursday before the third Friday of the month, with the settlement value typically determined based on Friday morning prices and processed that same day. Stock options, by contrast, have their last trading day on the third Friday of the month, with settlement typically processed the following business day.
Settlement Method
When settling stock options, the underlying stock typically changes hands upon the exercise of the contract. However, traders of index options typically settle their contracts in cash.
That’s because of the large number of securities involved. For example, an investor exercising a call option based on the S&P 500 would theoretically have to buy shares of all the stocks in that index.
What Are Options Trading Levels?
Some options trading strategies are more straightforward and may involve relatively lower investment risk compared to others. But there are ways to use options that can get rather complicated and may carry substantial risk. These strategies can typically be used with index options, though they may be subject to different expiration rules and brokerage approval standards. Some basic strategies (like buying puts) are widely accessible, while more complex trades involving spreads or uncovered positions also exist.
To help ensure investors are aware of the risks associated with various strategies, brokerages have something called options trading levels. Brokerages have enacted these levels to try to deter new investors from trading options they may not fully understand and experience significant losses in a short period.
If a brokerage determines that an investor faces a lower risk of seeing significant losses, and has the level of experience needed to manage risk, they can assign that investor a higher options trading level. Higher options levels open up a user’s account to additional investment strategies, which may enable them to trade different types of options.
Most brokerages offer four or five trading levels. Reaching all but the highest level usually requires completing a basic questionnaire to assess an investor’s knowledge.
Options Trading Level 1
This is the lowest level and typically allows a user to trade the simplest options only, such as covered calls and protective puts. A covered call is when an investor writes an out-of-the-money call option on stocks they own, and a protective put is when an investor buys put options on stocks already held.
These strategies require the trader to hold shares of the underlying stock, which may make these trades less risky than many others. There is also only one option leg to worry about, which can make executing the trade much simpler in practice.
Options Trading Level 2
Level 2 typically grants the right to buy calls and puts. The difference between level 2 and level 1 is that traders at level 2 can take directional positions. Most new traders are typically approved to start at this level.
Options Trading Level 3
At level 3, more complex strategies may become available. This level usually includes approval and margin to trade debit spreads. Though relatively complicated to execute, debit spreads may limit risk since the trader’s maximum loss is usually capped at the cash paid to buy the necessary options.
Options Trading Level 4
Level 4 may include permission to trade credit spreads, and is sometimes included in level 3 (in which case the brokerage would have only 4 levels). A credit spread functions similarly to a debit spread, although the trader receives a net premium upfront.
Calculating potential losses can be more complicated at this level. It is here that novice traders may inadvertently take on tremendous risk.
Options Trading Level 5
Level 5 involves the highest risk and may permit traders to write call options and put options without owning shares of the underlying stock. These trades expose investors to potentially unlimited losses and may be suitable only for very experienced options traders.
The most important requirement of level 5 is that an investor maintains sufficient margin in their account. That way, if an options trade moves against the investor, the broker can use the margin account to help cover potential losses.
Recommended: What Are Naked Options?
What Happens to Index Options On Expiry?
Most index options have a European-style exercise, although some index option series may differ. This means traders can only execute them at expiration. Investors may want to research which type of settlement their index options have before making a trade.
Upon expiration, the Options Clearing Corporation (OCC) may assign the option to one or more Clearing Members who have short positions in the same options. The Clearing Members may assign the option to one of their customers.
The index option writer is then responsible for paying any cash settlement amount. Settlement usually takes place on the next business day after expiration.
💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.
How to Trade Index Options
Trading index options may be one type of investment to consider as part of a broader diversified portfolio. For the most part, trading index options works like trading any other option. The big difference is that the underlying security will be an index, rather than a stock.
Here are a few basic steps that investors can consider when starting to trade index options.
• Request authorization from your brokerage for options trading
• Review how option chains are reflected in your brokerage account
• Study different option trading strategies and consider those that align with your level of expertise
• Before trading, develop a strategy for managing risk and closing out positions, if needed.
• Place a trade through your brokerage platform’s options account and monitor your trades.
The Takeaway
Index options are similar to stock options in that they are both financial derivatives. They are rooted in indexes, though, which typically reflect a segment or sector. Trading options and index options is a more complex strategy involving higher risk, and may not suit every investor’s risk tolerance.
Index investing with index options could appeal to investors looking to hedge their portfolios with alternative or derivative-based investments.
SoFi’s options trading platform offers qualified investors the flexibility to pursue income generation, manage risk, and use advanced trading strategies. Investors may buy put and call options or sell covered calls and cash-secured puts to speculate on the price movements of stocks, all through a simple, intuitive interface.
With SoFi Invest® online options trading, there are no contract fees and no commissions. Plus, SoFi offers educational support — including in-app coaching resources, real-time pricing, and other tools to help you make informed decisions, based on your tolerance for risk.
Frequently Asked Questions
What are examples of index options?
Examples of index options include contracts based on the S&P 500 (SPX), Nasdaq-100 (NDX), and Russell 2000 (RUT). These index options let traders take positions on overall market segments rather than individual stocks. Index options are typically cash-settled and European-style, meaning they may only be exercised at expiration.
What is the difference between stock options and index options?
Stock options are tied to individual companies and often involve share delivery. Index options, on the other hand, track a broader market index and are usually cash-settled. Most stock options are American-style, whereas index options are commonly European-style, meaning they can only be exercised at expiration.
What is the risk of index options?
Index options carry risks, including the potential for significant losses. Sudden shifts in economic conditions can affect their value, given that they track broad market movements. Strategies like selling uncovered options can involve high risk and aren’t suitable for all investors.
What are S&P 500 index options?
S&P 500 index options (SPX) are contracts based on the S&P 500. They’re cash-settled, European-style, and commonly used to hedge or speculate on overall market performance. SPX options are popular for their liquidity and broad market exposure.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
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