Index Options Trading
Index options trading were introduced into the financial market in 1981. Similar to equity options which are based on an underlying stock, index options are based on an underlying financial index.The main advantage of trading in index options is that it allows an investor to be diversified to the overall market or a sector of the financial market with just a single investment decision and one transaction.
Without index options trading, an investor will have to make several transactions to have the same level of diversification to the financial market.
As with other forms of options trading, index options trading permit an investor to have leverage with his limited capital and also have a quantifiable risk tagged to his investment by just paying a premium. With the leverage gained, the investor is able to reap a higher rate of profit in term of percentage gains as the premium paid is relatively cheap when compared to the option contract value.
With stock index options, an investor is not given the rights to purchase the actual underlying assets (stocks) of the index. Instead, he is given the right to demand from the option writer the equivalent cash value when he chooses to exercise the option. These stock index options normally have a ‘contract multiplier’, in the denomination of $100, which is used to calculate the cash value of the index option contract.
Although there are similarity between equity options and index options, there are also differences between these two (2) types of options, notably in terms of assignment and exercising procedures. With equity options, they are based on American style whereas index options can be either American style or European style. With regards to American style options, the investor can choose to exercise the rights conferred by the options anytime from the purchase date to the expiration date of the option. European style options are more restricted in the sense that they can only be acted upon on towards the end of the expiration date.
Another major difference between an equity option and an index option is the fact that for equity options, the underlying asset has to change hands between the parties of the option contract. Index options on the other hand, are cash settled in the sense that only cash changed hands to settle the difference of the contract value. It is not practical for the actual physical assets to change hands with regards to index option because of the number of assets that the index represents. Imagine if 500 types of shares have to physically change hands when an investor exercise an option for the S&P 500 index. Chaos will ensue if this was really the case.
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