Index Option

Author:

Reviewed By:

Last Updated:January 2, 2024

In This Article

What is an Index Option?

Financial derivatives are financial instruments tied to a specific financial instrument, indicator, or commodity and allow for trading certain financial risks on financial markets in their own right.

The term “derivative” describes a particular class of financial contract whose value is based on an underlying asset, a group of underlying assets, or a benchmark.

A derivative is agreed upon by two or more parties who may trade over the counter (OTC) or on an exchange.

Index options are financial derivatives contract that gets their value from an underlying stock market index. It grants the holder the option to purchase or sell the underlying index at a designated strike price but not the duty to do so.

Call and put options, which grant the holder the right to purchase and sell, respectively, are included in index options.

Like other options, they provide the buyer the option to go long (for a call) or short (for a put) the index’s value at a particular strike price, but not the obligation to do so.

There is no single stock on which index options are based. They instead concentrate on the price of a stock index. As a result, the investors cannot exchange an underlying share.

On the other hand, these options represent an agreement between investors to exchange money dependent on the value of the index.

That implies that the purchaser of options only makes the premium payment, which also serves as their limit on loss.

How does the Index option work?

These options do not comprise a particular stock as their underlying; instead, they have a pool of stocks based on the weights given to each stock in the index.

The index futures contracts or the underlying index itself is generally used as the underlying asset from which the option derives its value.

The underlying index cannot be physically delivered; hence the settlement is usually done on a cash basis. European options are often settled on the expiration day rather than during the contract period.

The index option grants the right to the buyer and seller to purchase a call option when they are bullish or short the market when they are bearish by buying a put option.

Index derivatives are low-to-high-risk tools used to profit from price fluctuations in the broader market.

If a trader is viewing an index that comprises 50 stocks and sees that the majority of them are falling and are bearish, he doesn’t need to short every stock; instead, he only needs to short an index option.

The profit potential is an option buyer is unlimited with limited downside risk, whereas being an option seller carries unlimited downside risk and limited profit potential.

The option multiplier that helps the trader or investor to determine the actual investment amount is typically 50 or 100.

One of the most alluring features of index options is the opportunity to experience little losses while having exposure to various equities at a much-reduced price.

In most situations, it is generally in the trader’s best interest to lock in any gains from a particular position and not wait until expiry for the option expires, as this can result in losing the capital gained or even lead to significant losses.

You can purchase the opposite option if you want to hedge your positions.

A Call option buyer with a bullish view of the market suspects that there can be some selling pressure at level A, then he can purchase a Put option of that same strike price (level A).

This will help him protect his downside risk and not lose money beyond a particular level.

Such strategies must be undertaken, keeping other things in perspective and not blindly. It depends on the size of your portfolio, the number of options purchased, the market volatility, etc.

Example of an option trade

An investor buys a Nifty 50 Index Put option with a bearish view, assuming the price will fall soon. Let’s look at the following example:

Index spot price: 17600
Put option strike price: 17500
Put option premium: $5
Contract multiplier: 50
Lots: 3
Contract cost: $750 [$5 x (50x3)]
Nifty 50 Index at expiry: 17400
Put option premium at the time of selling/expiry: $15

The above situation would lead to a profit as the option has expired. For example, in The Money (ITM), the market price was 17600, and the trader bought a Put option of strike 17500, expecting the price to fall.

At expiry, though, the market price of the index was 17400, and hence the trader stands to make a profit. The profit is determined by subtracting the index price at expiration and the strike price.

Profits if the Put option is exercised: $1500, i.e., ($15 - $5) x 150

Factors influencing the growth of derivative markets globally

The derivatives markets have grown astronomically over the past forty years. As a result, at exchanges all around the world, numerous derivative contracts were introduced. Several factors that contribute to the rise of financial derivatives include:

Increased volatility in the values of underlying assets in the financial markets.
Worldwide financial market integration.
Costs of transactions have decreased thanks to the use of modern communications technology.
Improved knowledge of advanced risk management technologies among market participants.
The newer product uses and frequent advancements in derivative markets have contributed to the growth of derivatives.
Market expansion and fiercer rivalry are both results of market globalization. Additionally, it has exposed contemporary businesses to substantial risks, frequently resulting in reduced profit margins.
Therefore, it is clear that using derivatives is necessary to protect against potential losses due to the globalization of industrial and financial activity.

The Greek Calculator

The Black and Scholes options pricing model, from which the name Black & Scholes derives, was first published by Fisher Black and Myron Scholes in 1973. Robert C.

Merton, however, improved the model and added complete mathematical knowledge to the pricing formula.

Because of how well-regarded this pricing model is in the financial world, Robert C. Merton and Myron Scholes shared the 1997 Nobel Prize in Economic Sciences. Mathematical principles like partial differential equations, normal distribution, stochastic processes, etc., are used in the B&S options pricing model.

Think of the ‘Greek Calculator’ as a box that takes in a bunch of input and gives out a bunch of outputs.

Market data for the options contract serves most of the required inputs, and the Option Greeks serve as the primary output.

This is how the pricing model’s framework operates:

Spot price, strike price, interest rate, implied volatility, dividend, and the number of days until expiration is the inputs we give the model.
The pricing model generates the necessary mathematical calculation and outputs several results.
The output includes all Option Greeks and the call and put option’s notional price for the chosen strike.

The inputs:

The spot price of the underlying: This is the current market price. The futures price may also be used in place of the current price. We utilize the futures price when the underlying of the option transaction is a future.
Interest rate: The interest rate is the market-prevailing, risk-free rate.
The number of days to expire: This indicates the number of days left for the contract to expire.
Volatility: The implied volatility of the option must be entered here. You can always derive the implied volatility information by looking at the option chain.

The call or put premium is determined by feeding the abovementioned variables into a Black-Scholes option pricing model. Estimating the payout is the most difficult aspect of index option pricing.

Types of Index Options

There are three different ways to classify index options, as shown below:

1. In contrast to index call options, which allow the holder the opportunity to buy the index, index put options grant the right to sell the index. The former is a bullish perspective in contrast to the latter.

2. The three subcategories under which index options can be categorized are ITM, OTM, and ATM. Executing options that are in the money or ITM would be profitable.

A loss is realized when exercising OTM options. Simply put, if you hold the Nifty 15,800 call option, it will be in-the-money (ITM) if the index is at 15,810 and out-of-the-money (OTM) if it is at 15,790.

While the second is more pessimistic, the first represents a bullish one.

3. The Nifty and Bank Nifty index options can currently be traded on Indian exchanges monthly and weekly. The weekly options expire every Thursday, whereas the monthly options expire on the final Thursday of each month.

Advantages Of Options

Options are significantly more liquid than both the cash market and the futures market in terms of daily volumes, in addition to being much larger.

Options are a unique investment instrument; therefore, it’s important to grasp their unique characteristics before choosing to trade them.

Some advantages of trading options include the following:

The improvement of price discovery based on actual valuations and expectations is made possible by derivatives markets.
The transfer of diverse hazards from individuals exposed to risk but with a low appetite for risk to participants with a high appetite for risk is made possible through derivatives markets. For instance, hedgers prefer to transfer risk, whereas traders are ready to do so.
Derivative markets assist the transition of speculative traders from unorganized to structured markets.
The financial system is kept stable through risk management procedures and monitoring of various participants’ activities in a controlled environment.
Options traders can wager on the direction or volatility of the entire equity market (or market segment) by using index options instead of trading options on all individual equities.
Investors can diversify their portfolios using options based on indexes rather than specific stocks.
These options are particularly popular for traders, hedge funds, and investment companies. Due to its popularity, the market’s spreads are quoted at lower levels while the volume available for trading increases.

Strategies for Trading Index Options

The trader/strategy designer’s imagination is the only thing that limits strategies. Newer methods will continue to be introduced to the market as long as traders can devise creative ways to combine different options.

The most commonly used option strategies are :

1. Option spreads

Options on the same underlying asset and of the same type (call/put) but with various strike prices and maturities are combined in option spreads. As a result, these positions have a maximum profit and maximum loss.

They can be divided mostly into three subgroups:

Horizontal spreads
Vertical spreads
Diagonal spreads

2. Straddle

This strategy involves two options of the same strike prices and same maturity. For example, a long straddle position is created by buying a call and a put option of the same strike price and same expiry, whereas a short straddle is created by shorting a call and a put option of the same strike and same expiry.

3. Strangle

This technique has a similar outlook to straddle but differs in execution, aggressiveness, and expense. Furthermore, it comes in two varieties: Long and short.