Earlier in this unit, you briefly learned about index options. This chapter covers index options in more 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, stays flat, or rises. Index options are used to speculate on general market movements, generate additional income, or protect entire portfolios from market risk.
Instead of investing based on changes in a single stock’s price, index option investors are taking a position on changes in an index’s value. While there are many indices with listed options, these are the ones most likely to appear on the exam:
SPX - S&P 500
OEX - S&P 100
DJX - Dow Jones Industrial Average
RUT - Russell 2000
VIX - Volatility index
Indices provide a “high-level” view of the market. You’ve probably seen the news discuss the Dow Jones and the S&P 500, which are commonly used to gauge U.S. market performance. Different indices highlight different parts of the market.
For example, if the Russell 2000 is down but the S&P 100 is up, that suggests small-cap stocks are having a rough day while large-cap stocks are doing well.
Throughout this chapter, you’ll see that index options work a lot like equity options. However, there are two key differences to keep in mind.
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 major exception: the OEX (S&P 100). The reason isn’t important here, 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 is how exercise is settled. When an index option is exercised, no shares are bought or sold. Think about what it would mean if an S&P 500 option worked like an equity option - exercise would require trading shares across 500 different companies. Because indices represent baskets of securities, index option exercises settle in cash.
When a holder exercises an index option, the writer must deliver the “in the money” amount (the intrinsic value) in cash. We’ll explore this concept later in the chapter.
When an equity option is exercised, settlement occurs over one business day (T+1). With an index option, there are no shares traded at exercise, so index options also maintain a settlement of 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
Just like a regular equity option, long calls have unlimited gain potential. The investor has the right to buy at 4,500. The further the S&P 500 index rises above 4,500, the more the investor makes.
If the S&P 500 index is below 4,500 at expiration, the option is “out of the money” and will expire worthless. The worst-case outcome for an option holder is losing the premium paid. A $20 premium equals $2,000 ($20 x 100 multiple).
If the S&P 500 index rises to 4,520, the contract is “in the money” by $20. When the holder exercises, the writer must deliver the intrinsic value in cash. With the option $20 “in the money,” the writer must deliver $2,000 ($20 x 100 multiple), which offsets the original $2,000 premium paid.
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, so the net result is a $3,000 profit.
At 4,450, the contract is “out of the money” and expires worthless. The holder loses the $2,000 premium ($20 x 100 multiple), which is the maximum loss.
As you may have noticed, index options aren’t much different from equity options. You can use the same formulas from the long calls chapter to answer the questions in this 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
The maximum gain on any short option is the premium received. Short puts are bullish, and the investor wants the RUT to stay above 2,000. If that happens, the option is “out of the money,” expires worthless, and the investor keeps the $1,500 ($15 x 100) premium as profit.
Short puts lose more as the market falls. If the RUT goes below 2,000, the contract goes “in the money” (it gains intrinsic value). Theoretically, the index could fall 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).
If the RUT falls to 1,985, the contract is “in the money” by $15. The holder (the long side) would exercise, forcing the investor to deliver the intrinsic value in cash. With intrinsic value of $15, the investor must deliver $1,500 ($15 x 100) to the holder. That $1,500 loss offsets the $1,500 premium received when the option was sold.
At 2,040, the contract is “out of the money” and will expire worthless. The investor keeps the $15 premium, for an overall gain of $1,500 ($15 x 100).
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, which reduces the overall loss to $2,500.
Again, the fundamentals of options still apply. You can use the same formulas from the short put chapter to answer the questions from this 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 saw market risk in action. In March 2020 alone, the S&P 500 lost over 12%. A 12% decline over a full year is bad enough, but a sharp drop in a single month can be devastating.
There are always exceptions, but most investors lost significant money during this market downturn. Even a well-diversified portfolio with investments across sectors and geographic regions would likely have experienced substantial losses. The vast majority of businesses saw revenue decline due to the “shutdown” of the economy. This is why investors cannot diversify out of market risk.
While you can’t diversify away market risk, you can hedge against it. One way to hedge is to buy (go long) an option that profits when the market moves against your portfolio.
For example, investors with large diversified portfolios may buy (go long) index puts to protect against market risk. If an unexpected recession occurs, gains from a bearish long index put could help offset losses in the rest of the portfolio.
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