While stock options derive their value from the performance of a single stock, index options are derivatives of an index. Indexes can have a narrow focus on a specific market sector or they can contain a broader mix of stocks. They’re listed on U.S. option exchanges and regulated by the Securities and Exchange Commission (SEC).
Like stock options, the prices of index options fluctuate according to factors like the value of the underlying security, volatility, time left until expiration, strike price, and interest rates. Unlike stock options, there is no underlying asset with index options, they’re simply bets on the direction that an index will move.
What Is An Index Call Option?
An index call option is a financial derivative that represents a bullish bet on the underlying index. An investor who buys an option of this kind believes that the index in question will rise in value. If the index appreciates, so too will the call option.
Before getting too far into the weeds when it comes to 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 confusing segment of the financial market.
💡 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.
What Is An Index Put Option?
An index put option is a bearish bet on the underlying index. An investor who buys this derivative believes that its underlying index will decline in value.
Differences Between Index Options and Stock Options
In addition to the existence of an underlying security, there are several key differences between trading index options and trading stock options. It’s important for investors to understand these differences.
Trading Hours
Broad-based indexes stop trading at 4:15 PM Eastern Time while stock options and narrow-based index options end their trading fifteen minutes earlier, at 4:00 PM ET. When significant news drops after the market closes, this could impact the prices of narrow-based index options and stock options.
Broad-based indexes are less likely to be affected, however, because they tend to include more sectors in their baskets of securities.
Recommended: When Is the Stock Market Closed?
Settlement Date and Style
While stock options use the American-style of exercise, meaning options holders can exercise at any point leading up to expiration, most index options have European-style exercise (with some exceptions). That means the trader can’t exercise the option until their expiration date. However, traders can still close out their index option positions by buying or selling throughout the life of the contract.
As for settlement date, stock index options usually have their last trading day on the Thursday before the third Friday of the month, with determination of the settlement value coming on Friday. Stock options, by contrast, have their last trading day on the third Friday of the month, with settlement being determined on Saturday.
Settlement Method
When settling stock options, the underlying stock changes hands upon the exercise of the contract. However, traders of index options settle their contracts in cash.
That’s because of the number of securities involved. For example, an investor exercising a call option based on the S&P 500 would have to buy shares of all the stocks in that index.
What Are Options Trading Levels?
Some options trading strategies are simple and come with relatively low investment risk. But there are other ways to use options that can get rather complicated and come with substantial risk.
To make sure that investors are aware of the bets they are making and the risks involved, brokerages have something called options trading levels. Brokerages have enacted these levels to protect themselves from liability if new investors lose large amounts of money in a short period when trading options they don’t understand.
If a brokerage believes an investor faces a low risk of potentially blowing up their whole account through complex options trading, they’ll assign that investor a higher options trading level. Higher options levels open up a user’s account to additional investment strategies, enabling them to trade different types of options.
Most brokerages have four or five trading levels. Reaching all but the highest level usually involves little more than answering some questions and taking a quiz to test an investor’s knowledge.
Options Trading Level 1
This is the lowest level and most often only allows a user to trade the simplest options like 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 against stocks they own.
These strategies require the trader to hold shares of the underlying stock, making these trades less risky than many others. There is also only one option leg to worry about, which makes executing the trade much simpler in practice.
Options Trading Level 2
Level 2 comes with the right to buy calls and puts. The difference between level 2 and level 1 is that traders at level 2 can make directional bets. Most new traders begin their accounts at this level.
Options Trading Level 3
At level 3, more complex strategies start to come into play. This level usually brings with it the ability to trade debit spreads. Though complicated to execute, debit spreads still limit risk since the trader’s loss is limited to the cash paid to buy the necessary options.
Options Trading Level 4
Level 4 provides traders the ability to trade credit spreads, and is sometimes included in level 3 (in which case the brokerage would have only 4 levels). A credit spread works like a debit spread, although the trader will receive a premium.
Calculating potential losses becomes more complicated at this level. It is here that novice traders can wind up accidentally exposing themselves to tremendous risk.
Options Trading Level 5
Level 5 brings with it the highest risk, allowing traders to write call options and put options without owning shares of the underlying stock. These trades expose investors to potentially unlimited losses and should be avoided by all but the most experienced options traders.
The most important requirement of level 5 is that an investor keeps adequate cash as margin in their account. That way, if an options trade moves against the investor, the broker can take cash to cover the losses created by the bad trade.
Recommended: What Are Naked Options?
What Happens to Index Options On Expiry?
Most index options have European-style exercise, meaning traders can only execute them upon expiration. Investors should conduct the appropriate research to learn which type of exercise their index options have before making a trade.
Upon expiration, the Options Clearing Corporation (OCC) assigns the option to one or more Clearing Members who have short positions in the same options. The Clearing Members then assign the option to one of their customers.
The index option writer must then pay the settlement amount in cash. Settlement usually occurs on the business day following the exercise.
💡 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.
How To Trade Index Options
Trading index options may be one type of investment to consider as part of a 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 stock.
Here are a few basic steps that investors can follow to begin trading index options.
• Get your brokerage account authorized for options trading
• Get familiar with how the options chains look in your brokerage account
• Study different option trading strategies and pick one appropriate for your level of expertise
• Enter an option trade using the trading screens of your account
• Monitor your option trades and make a plan for closing out positions to either lock in profits or cut losses.
The Takeaway
Index options are similar to stock options, in some ways, in that they are financial derivatives. They are rooted in indexes, though, which are focused on a segment or portion of the overall market. Trading options and index options, though, is a high-level activity, and may not be for all investors.
Index investing with index options could appeal to investors looking to hedge their portfolios with different types of investments. If an investor holds a lot of positions within a particular index, or perhaps an index fund or other low-fee ETFs, put options for that index could serve as a hedge, for example.
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