Stock index options wikipedia

A stock index is a compilation of several stock prices into a single number. Indexes come in various shapes and sizes. Some are broad-based and measure moves in broad, diverse markets.

Others are narrow-based and measure more specific industry sectors of the marketplace. Understand that it is not the number of stocks that comprise the average that determine if an index is broad-based or narrow-based, but rather the diversity of the underlying securities and their market coverage.

Different stock indexes can be calculated in different ways.

Accordingly, even where indexes are based on identical securities, they may measure the relevant market differently because of differences in methods of calculation. An index can be constructed so that weightings are biased toward the securities of larger companies, a method of calculation known as capitalization-weighted.

In calculating the index value, the market price of each component security is multiplied by the number of shares outstanding. This will allow a security's size and capitalization to have a greater impact on the value of the index. Another type of index is known as equal dollar-weighted and assumes an equal number of shares of each component stock.

This index is calculated by establishing an aggregate market value for every component security of the index and then determining the number of shares of each security by dividing this aggregate market value by the current market price of the security.

This method of calculation does not give more weight to price changes of the more highly capitalized component securities. An index can also be a simple average: Another type measures daily percentage movements of prices by averaging the percentage price changes of all securities included in the index. An equity index option is an option whose underlying instrument is intangible - an equity index.

The price of an index call will generally increase as the level of its underlying index increases, and its purchaser has unlimited profit potential tied to the strength of these increases. The price of an index put will generally increase as the level of its underlying index decreases, and its purchaser has substantial profit potential tied to the strength of these decreases.

Generally, the factors that affect the price of an index option are the same as those affecting the price of an equity option: The underlying instrument of an equity option is a number of shares of a specific stock, usually shares.

Cash-settled index options do not relate to a particular number of shares. Rather, the underlying instrument of an index option is usually the value of the underlying index of stocks times a multiplier, which is generally U. Indexes, by their nature, are less volatile than their individual component stocks.

Index Option

The up and down movements of component stock prices tend to cancel one another out, lessening the volatility of the index as a whole. However, the volatility of an index can be influenced by factors more general than can affect individual equities. These can range from investors' expectations of changes in inflation, unemployment, interest rates or other economic indicators issued by the government and political for military situations.

Like equity options, index options offer the investor an opportunity to either capitalize on an expected market move or to protect holdings in the underlying instruments. The difference is that the underlying instruments are indexes. These indexes can reflect the characteristics of either the broad equity market as a whole or specific industry sectors within the marketplace. Index options enable investors to gain exposure to the market as a whole or to specific segments of the market with one trading decision and frequently with one transaction.

To obtain the same level of diversification using individual stock issues or individual equity option classes, numerous decisions and transactions would be required. Employing index options can defray both the costs and complexities of doing so. Unlike other investments where the risks may have no limit, index options offer a known risk to buyers.

An index option buyer absolutely cannot lose more than the price of the option, the premium. Index options can provide leverage. This means an index option buyer can pay a relatively small premium for market exposure in relation to the contract value. An investor can see large percentage gains from relatively small, favorable percentage moves in the underlying index. If the index does not move as anticipated, the buyer's risk is limited to the premium paid.

However, because of this leverage, a small adverse move in the market can result in a substantial or complete loss of the buyer's premium. Writers of index options can bear substantially greater, if not unlimited, risk. As with an equity option, an index option buyer's risk is limited to the amount of the premium paid for the option.

The premium received and kept by the index option writer is the maximum profit a writer can realize from the sale of the option. However, the loss potential from writing an uncovered index option is generally unlimited. Any investor considering writing index options should recognize that there are significant risks involved.

The differences between equity and index options occur primarily in the underlying instrument and the method of settlement. Generally, when an index option is exercised by its holder, and when an index option writer is assigned, cash changes hands. Only a representative amount of cash changes hands from the investor who is assigned on a written contract to the investor who exercises his purchased contract.

This is known as cash settlement. Purchasing an index option does not give the investor the right to purchase or sell all of the stocks that are contained in the underlying index. Because an index is simply an intangible, representative number, you might view the purchase of an index option as buying a value that changes over time as market sentiment and prices fluctuate.

An investor purchasing an index option obtains certain rights per the terms of the contract. In general, this includes the right to demand and receive a specified amount of cash from the writer of a contract with the same terms. Available strike prices, expiration months and the last trading day can vary with each index option class, a term for all option contracts of the same type call or put and style American, European or Capped that cover the same underlying index.

To determine the contract terms for the option class es you wish to employ, please contact either the exchange where the option is traded or The Options Industry Council. The strike price, or exercise price, of a cash-settled option is the basis for determining the amount of cash, if any, that the option holder is entitled to receive upon exercise. See Exercise Settlement for further explanation. An index call option is in-the-money when its strike price is less than the reported level of the underlying index.

It is at-the-money when its strike price is the same as the level of that index and out-of-the-money when its strike price is greater than that level. An index put option is in-the-money when its strike price is greater than the reported level of the underlying index.

It is at-the-money when its strike price is the same as the level of that index and out-of-the-money when its strike price is less than that level. Premiums for index options are quoted like those for equity options, in dollars and decimal amounts.

The writer, on the other hand, will receive and keep this amount. The amount by which an index option is in-the-money is called its intrinsic value. Any amount of premium in excess of intrinsic value is called an option's time value. As with equity options, time value is affected by changes in volatility, time until expiration, interest rates and dividend amounts paid by the component securities of the underlying index.

The exercise settlement value is an index value used to calculate how much money will change hands, the exercise settlement amount, when a given index option is exercised, either before or at expiration.

The value of every index underlying an option, including the exercise settlement value, is the value of the index as determined by the reporting authority designated by the market where the option is traded. Unless OCC directs otherwise, the value determined by the reporting authority is conclusively presumed to be accurate and deemed to be final for the purpose of calculating the exercise settlement amount. In order to ensure that an index option is exercised on a particular day before expiration, the holder must notify his brokerage firm before the firm's exercise cut-off time for accepting exercise instructions on that day.

On expiration days, the cut-off time for exercise may be different from that for an early exercise before expiration.

Option (finance) - Wikipedia

Different firms may have different cut-off times for accepting exercise instructions from customers, and those cut-off times may be different for different classes of options. In addition, the cut-off times for index options may be different from those for equity options. Upon receipt of an exercise notice, OCC will assign it to one or more Clearing Members with short positions in the same series in accordance with its established procedures.

The Clearing Member will, in turn, assign one or more of its customers, either randomly or on a first-in first-out basis, who hold short positions in that series. Upon assignment of the exercise notice, the writer of the index option has the obligation to pay this amount of cash. Settlement and the resulting transfer of cash generally occur on the next business day after exercise. Most firms require their customers to notify the firm of the customer's intention to exercise at expiration, even if an option is in-the-money.

You should ask your firm to thoroughly explain its exercise procedures, including any deadline your firm may have for exercise instructions on the last trading day before expiration. The exercise settlement values of equity index options are determined by their reporting authorities in a variety of ways.

The two most common are: PM settlement - Exercise settlement values are based on the reported level of the index calculated with the last reported prices of the index's component stocks at the close of market hours on the day of exercise. AM settlement - Exercise settlement values are based on the reported level of the index calculated with the opening prices of the index's component stocks on the day of exercise. If a particular component security does not open for trading on the day the exercise settlement value is determined, the last reported price of that security is used.

Investors should be aware that the exercise settlement value of an index option that is derived from the opening prices of the component securities may not be reported for several hours following the opening of trading in those securities. A number of updated index levels may be reported at and after the opening before the exercise settlement value is reported. There could be a substantial divergence between those reported index levels and the reported exercise settlement value.

Although equity option contracts generally have only American-style expirations, index options can have either American- or European-style. In the case of an American-style option, the holder of the option has the right to exercise it on or at any time before its expiration date.

Otherwise, the option will expire worthless and cease to exist as a financial instrument. It follows that the writer of an American-style option can be assigned at any time, either when or before the option expires, although early assignment is not always predictable. A European-style option is one that can only be exercised during a specified period of time prior to its expiration.

This period may vary with different classes of index options. Likewise, the writer of a European-style option can be assigned only during this exercise period. The amount of cash received upon exercise of an index option or when it expires depends on the closing value of the underlying index in comparison to the strike price of the index option.

The amount of cash changing hands is called the exercise settlement amount. This calculation applies whether the option is exercised before or at its expiration. In the case of a call, if the underlying index value is above the strike price, the holder may exercise the option and receive the exercise settlement amount. For example, with the settlement value of the index reported as The writer of the option would pay the holder this cash amount.

In the case of a put, if the underlying index value is below the strike price, the holder may exercise the option and receive the exercise settlement amount. As with equity options, an index option writer wishing to close out his position buys a contract with the same terms in the marketplace. In order to avoid assignment and its inherent obligations, the option writer must buy this contract before the close of the market on any given day to avoid notification of assignment on the next business day.

To close out a long position, the purchaser of an index option can either sell the contract in the marketplace or exercise it if profitable to do so. The above content is provided for educational and informational purposes only, does not constitute a recommendation to enter in any of the securities transactions or to engage in any of the investment strategies presented in such content, and does not represent the opinions of TradeKing or its employees. TradeKing provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment advice.

You alone are responsible for evaluating the merits and risks associated with the use of our systems, services or products. All investments involve risk, losses may exceed the principal invested, and the past performance of a security, industry, sector, market, or financial product does not guarantee future results or returns. Your use of this service is conditioned to your acceptance of the terms of TradeKing disclosures. An Introduction What is an Index?

Capitalization-Weighted An index can be constructed so that weightings are biased toward the securities of larger companies, a method of calculation known as capitalization-weighted. Equal Dollar-Weighted Another type of index is known as equal dollar-weighted and assumes an equal number of shares of each component stock.

Other Types An index can also be a simple average: Index Options An equity index option is an option whose underlying instrument is intangible - an equity index. Pricing Factors Generally, the factors that affect the price of an index option are the same as those affecting the price of an equity option: Underlying Instrument The underlying instrument of an equity option is a number of shares of a specific stock, usually shares.

Volatility Indexes, by their nature, are less volatile than their individual component stocks. Benefits of Listed Index Options Like equity options, index options offer the investor an opportunity to either capitalize on an expected market move or to protect holdings in the underlying instruments. Diversification Index options enable investors to gain exposure to the market as a whole or to specific segments of the market with one trading decision and frequently with one transaction.

Predetermined Risk for Buyer Unlike other investments where the risks may have no limit, index options offer a known risk to buyers. Leverage Index options can provide leverage. Risk As with an equity option, an index option buyer's risk is limited to the amount of the premium paid for the option.

Cash Settlement The differences between equity and index options occur primarily in the underlying instrument and the method of settlement. Purchasing Rights Purchasing an index option does not give the investor the right to purchase or sell all of the stocks that are contained in the underlying index.

Option Classes Available strike prices, expiration months and the last trading day can vary with each index option class, a term for all option contracts of the same type call or put and style American, European or Capped that cover the same underlying index. Strike Price The strike price, or exercise price, of a cash-settled option is the basis for determining the amount of cash, if any, that the option holder is entitled to receive upon exercise.

In-the-money, At-the-money, Out-of-the-money An index call option is in-the-money when its strike price is less than the reported level of the underlying index.

Premium Premiums for index options are quoted like those for equity options, in dollars and decimal amounts.

European Exercise Although equity option contracts generally have only American-style expirations, index options can have either American- or European-style. Exercise Settlement The amount of cash received upon exercise of an index option or when it expires depends on the closing value of the underlying index in comparison to the strike price of the index option. Exercise Settlement Continued In the case of a call, if the underlying index value is above the strike price, the holder may exercise the option and receive the exercise settlement amount.

Closing Transactions As with equity options, an index option writer wishing to close out his position buys a contract with the same terms in the marketplace. V iew A ttachments 3. Enter labels to add to this page: Looking for a label?