What is an index option?

An index option is a financial derivative that gives its holder the right (but not the obligation) to buy or sell the value of an underlying index, such as the SandP 500 index, at the price of indicated exercise. No real shares are bought or sold. Often an index option uses an index futures contract as the underlying asset. Index options are always cash settled and are generally European-style options, i.e. they only settle on the expiration date and do not provide for early exercise.


Index options are option contracts that use a benchmark index, or a futures contract based on that index, as the underlying instrument.

Index options are generally European style and are settled in cash at the value of the index at expiration.

Like all options, index options will give the buyer the right, but not the obligation, to go long (for a call) or short (for a put) on the value of the index at a predetermined strike price.

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.

1 – Pricing of an Index Option

Option pricing is the primary and preferably the maximum complicated one to do. Pricing manner what top class and choice client is needed to pay prematurely to count on the proper to buy (or sell). Option Premium theoretically may be calculated through the use of a replicating portfolio, the use of hedge ratios and binomial bushes however extra superior strategies like Black Scholes Merton pricing formula, Vanna Volga pricing, etc. are utilized in Financial Markets types.

The top class paid through the choice client is calculated through the use of numerous strategies. The not unusual place inputs for Option Premium calculations are Spot Price, Strike Price, Days to expiry, Volatility of Stock Price, Risk-unfastened fee of go back, dividends, if any, etc.

The fundamental trouble related to the above fashions in pricing the index alternatives is the way to account for the dividends related to exclusive shares withinside the basket of the index. To estimate the dividend component, a person’s inventory’s dividend wishes to be ascertained and weight in shares to every inventory withinside the index.

2 – Valuation or Mark to Market of an Ongoing Option Contract

The Value of the Call Option to the client (Or seller) after the settlement until expiry continues converting. Depending on that, both celebrations can terminate the alternative settlement by paying cancellation costs as agreed through each party. The calculation worried in Valuation is just like the pricing of the choice. Parameters which include volatility, time to expiry risk-unfastened fee of going back continue converting relying on how economic markets are working.

Advantages of ​index options

Here are the advantages of these options.

Diversification: Index options are based on a large basket of stocks. This offers investors an easy diversification alternative.

: Index options are less volatile, hence easier to predict

Liquidity: As index options are popular with traders, hedge funds and investment firms, there is sufficient volume available for trading to keep an eye on the bidisk spread and prices are very close to a fair price.

Cash settled: Index options are settled in cash. This makes settlement easier than the actual delivery of shares in stock options.

Relatively inexpensive investment alternative to purchasing individual stock options

Disadvantages of ​index options

The limitations of index options are listed below.

Index options, being somewhat less profitable, may not be attractive to investors willing to take more risks to earn more.

Option pricing models are very complex and considering indices as underlying becomes too complex to evaluate.


Index options can be used to hedge a portfolio of individual stocks or speculate on the index’s future performance. Investors can implement various options trading strategies with index options, namely up spreads, down spreads, covered calls, and protective put options. These strategies may result in lower profits, but the risk is greatly reduced.

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