Understanding an Index Option
Index call and put options are popular instruments used to trade the general direction of an underlying index with very little capital at risk. The profit potential of index call options is unlimited, while the risk is limited to the premium paid for the option. For index put options, the risk is also limited to the premium paid, while the potential profit is limited to the level of the index, minus the premium paid because the index can never fall below zero.
In addition to the potential profit from general movements in the level of the index, index options can be used to diversify a portfolio when an investor is not willing to invest directly in the underlying stocks of the index. Index options can also be used to hedge specific risks in a portfolio. Note that while American-style options can be exercised any time before expiration, index options tend to be European-style and can only be exercised on the expiration date.
Instead of directly replicating an index, most index options use an index futures contract as the underlying security. An option on a SandP 500 futures contract can therefore be considered as a second derivative of the SandP 500 index since the futures contracts are themselves derivatives of the index.
Therefore, there are more variables to consider as both the option and the futures contract have their expiration dates and risk/reward profiles. With such index options, the contract has a multiplier that determines the overall premium, or price paid.
