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 focusing on the price movement of a single stock, index option investors take positions based on changes in an index’s value. There are many indices with listed options, but 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 give you 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 conditions. Different indices highlight different parts of the market. For example, if the Russell 2000 is down but the S&P 100 is up, you can infer that small-cap stocks are having a weaker day while large-cap stocks are holding up better.
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. That’s 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 settled 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 the holder exercises an in-the-money index option, the writer must pay the in-the-money amount (intrinsic value) in cash. We’ll build on this idea later in the chapter.
When an equity option is exercised, settlement occurs over one business day (T+1). With an index option, there are still no shares exchanged at exercise, and 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 an equity option, a long call has 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 profits.
If the S&P 500 index is at or below 4,500 at expiration, the call is out of the money and expires worthless. The worst-case outcome for the holder is losing the premium paid. A $20 premium equals $2,000 ($20 x 100 multiple).
At 4,520, the call is in the money by $20. If exercised, the writer must deliver the intrinsic value in cash. Here, $20 of intrinsic value means a $2,000 cash payment ($20 x 100 multiple), which exactly offsets the $2,000 premium paid.
At 4,550, the call is in the money by $50. At exercise, the writer must deliver $5,000 ($50 x 100 multiple) in cash. Subtract the $2,000 premium paid, and the net profit is $3,000.
At 4,450, the call 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 can see, index options aren’t very different from equity options in terms of payoff calculations. 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. A short put is bullish, so the investor wants the RUT to stay above 2,000. If it does, the put expires worthless and the investor keeps the $1,500 ($15 x 100) premium as profit.
A short put loses more as the market falls. If the RUT drops below 2,000, the put goes in the money and gains intrinsic value. Theoretically, the index could fall to zero (though this is extremely unlikely).
Maximum loss for a short put is calculated as (strike price - premium). Here, 2,000 - 15 = 1,985. If the index were at zero, the put would be in the money by 1,985, producing a loss of $198,500 ($1,985 x 100).
At 1,985, the put is in the money by $15. If exercised, the writer must deliver $1,500 ($15 x 100) in cash. That $1,500 loss at exercise is exactly offset by the $1,500 premium received when the option was sold.
At 2,040, the put is out of the money and expires worthless. The investor keeps the $15 premium, for a total gain of $1,500 ($15 x 100).
At 1,960, the put is in the money by $40. When assigned, the writer must deliver $4,000 ($40 x 100) in cash. Since the writer received $1,500 in premium upfront, the net loss is $2,500.
Again, the same option fundamentals apply. You can use the formulas from the short put chapter to answer the questions in 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 difficult; a drop of that size in a single month can be devastating.
There are always exceptions, but most investors experienced significant losses during that downturn. Even a well-diversified portfolio across sectors and geographic regions would likely have declined, because many businesses saw revenue fall during 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 common approach is to buy (go long) an option that tends to profit when the market moves against you.
For example, investors with large, diversified portfolios may buy (go long) index puts to help protect against broad market declines. If an unexpected recession occurs, gains from a bearish long index put could help offset losses elsewhere in the portfolio.
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