Index options
Earlier in this unit, you briefly learned about index options. This chapter covers this type of options contract in detail.
Index options derive their value from fluctuations in a specific index’s value. For example, you could invest in an S&P 500 index option that may provide a return if the index value falls, is flat, or rises. Index options are used to speculate on general market movements, make additional income, or protect entire portfolios from market risk.
Instead of investing based on stock price changes, index options investors bet on index value fluctuations. While there are numerous indices available to trade options on, these are most likely to appear on the exam:
SPX - S&P 500
- Tracks 500 large-cap US traded companies
OEX - S&P 100
- Tracks 100 large-cap US traded companies
- Subset of the S&P 500
DJX - Dow Jones Industrial Average
- Tracks 30 large-cap US traded companies
RUT - Russell 2000
- Tracks 2,000 small-cap US traded companies
VIX - Volatility index
- Tracks volatility of the market
Indices provide a “high-level” view of the market. You’ve probably seen the news discuss the Dow Jones and the S&P 500, both commonly used to gauge the U.S. markets and economy. Various indices provide different perspectives on the market. For example, if the Russell 2000 is down but the S&P 100 is up, it can be assumed small businesses are having a rough day in the market, but large businesses are doing well.
Throughout this chapter, you’ll learn how index options are similar to equity options. However, there are two distinct differences you should be aware of.
First, you learned in a previous chapter that most index options are European style, meaning they can only be exercised at expiration. This is true for virtually all index options with one big exception - the OEX (S&P 100). The reason is unimportant, but the OEX is one of the only American style index options, meaning it can be exercised at any time. As a reminder, all equity (stock) options are American style.
The second difference relates to exercise. When an index option is exercised, shares are not bought or sold. Think about it - if an S&P 500 option worked the way equity options do, 500 shares of stock would be traded at exercise. Due to the size of indices, all index option exercises settle in cash. When a holder exercises their index option, the writer must deliver the “in the money” amount in cash. We’ll explore concept later in this chapter.
When an equity option is exercised, settlement occurs over one business day (T+1). Investors trade stock during an equity option exercise; therefore, the stock settlement time of T+1 is adopted. With an index option, no shares are traded at exercise, but the option itself still settles in T+1.
Let’s jump into some math-based index option questions. Assume this position:
Long 1 SPX 4500 call at $20
Using your fundamental options knowledge, find the following:
- Maximum gain
- Maximum loss
- Breakeven
- Gain or loss at 4,550
- Gain or loss at 4,450
- Maximum gain = unlimited
Just like a regular equity option, long calls have unlimited gain potential. The investor maintains the “right to buy” at 4,500. The further the S&P 500 index rises above 4,500, the more the investor makes.
- Maximum loss = $2,000 (premium)
If the S&P 500 index goes below 4,500, the option is “out of the money” and will expire worthless. The worst-case scenario for an option holder is to lose the premium. A $20 option premium equals $2,000 ($20 x 100 multiple).
- Breakeven = 4,520 (strike + premium)
If the S&P 500 index rises to 4,520, the contract is “in the money” by $20. When the holder exercises the contract, the writer must deliver the “in the money” (intrinsic value) amount in cash. With the option $20 “in the money,” the writer must deliver $2,000 in cash ($20 x 100 multiple) to the holder, which offsets the original $2,000 premium paid.
- Gain or loss at 4,550 = $3,000 gain
At 4,550, the contract is “in the money” by $50. At exercise, the writer must deliver $5,000 ($50 x 100 multiple) to the holder. The holder paid $2,000 upfront to buy the option, which partially offsets the gain from exercise. The investor is left with an overall $3,000 profit.
- Gain or loss at 4,450 = $2,000 loss
At 4,450, the contract is “out of the money” and expires worthless. The holder loses their $2,000 premium ($20 x 100 multiple), their maximum loss.
As you may have noticed, index options are not much different from equity options. In fact, you can use all the formulas from the long call chapter to answer the questions in the previous scenario.
Let’s try another example:
Short 1 RUT 2000 put @ $15
Using your fundamental options knowledge, find the following:
- Maximum gain
- Maximum loss
- Breakeven
- Gain or loss at 2,040
- Gain or loss at 1,960
- Maximum gain = $1,500 (premium)
The maximum gain on any short option is always the premium. Short puts are bullish, and the investor hopes the RUT stays above 2,000. If this occurs, the option is “out of the money,” expires worthless, and the investor keeps the $1,500 ($15 x 100) premium as a profit.
- Maximum loss = $198,500 (strike - premium)
Short puts lose more the further the market falls. If the RUT goes below 2,000, the contract goes “in the money” (gains intrinsic value). Theoretically, the index could go to zero, although this will probably never happen (all 2,000 businesses in the Russell 2000 index would have to go out of business).
A short put’s maximum loss is calculated by subtracting the premium from the strike price (2,000 - 15). At zero, the option would be “in the money” by $1,985, resulting in an overall loss of $198,500 ($1,985 x 100).
- Breakeven = 1,985 (strike - premium)
If the RUT falls to 1,985, the contract is “in the money” by $15. The holder (the long side) would exercise the contract, forcing the investor to deliver the “in the money” amount (intrinsic value) in cash. With the intrinsic value being $15, the investor must deliver $1,500 ($15 x 100) in cash to the holder. The $1,500 loss at exercise offsets the $1,500 premium received when this option was initially sold.
- Gain or loss at 2,040 = $1,500 gain
At 2,040, the contract is “out of the money” and will expire worthless. The investor keeps the $15 premium with no additional action required, which amounts to an overall gain of $1,500 ($15 x 100).
- Gain or loss at 1,960 = $2,500 loss
At 1,960, the contract is “in the money” by $40. When assigned (exercised), the writer must deliver $4,000 ($40 x 100) to the holder. The writer received $1,500 upfront to sell the option, which reduces the overall loss to $2,500.
Again, the fundamentals of options continue to apply. You can use all the formulas from the short put chapter to answer the questions from the previous scenario.
Investors commonly use index options to hedge against market risk, a type of systematic risk.
If you had money invested during the initial outbreak of COVID-19 (Coronavirus), you surely understand market risk. In March 2020 alone, the S&P 500 lost over 12%. A market loss of 12% over a year is bad enough, but a drastic decline in one month is devastating.
There are always exceptions, but most investors lost significant money during this market downfall. Even a well-diversified portfolio with investments from various sectors and geographic locations would likely experience substantial losses. The vast majority of businesses saw a decline in business revenue due to the “shutdown” of the economy. This is an example of why investors cannot diversify out of market risk.
While you can’t diversify out of market risk, you can hedge against it. An investor can protect themselves by going long an option that profits during an adverse market movement.
Investors with large diversified portfolios of investments could buy (go long) index puts to protect against market risk. If something like an unexpected recession occurs, the gains from a bearish long index put could offset the losses from other investments in the portfolio.
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