Earlier in this unit, you briefly learned about index options. This chapter looks at 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, 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 of one stock, index option investors focus 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 a “high-level” view of the market. You’ll often hear the news discuss the Dow Jones and the S&P 500 as quick gauges of 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 weaker day while large-cap stocks are doing 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 what happens at exercise. When an index option is exercised, no shares are bought or sold. If an S&P 500 option worked like an equity option, exercise would involve trading shares of 500 different stocks.
Because indices represent many securities, index option exercises settle in cash. When a holder exercises an 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). Index options also settle T+1.
Let’s work through 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 below 4,500 at expiration, the option is “out of the money” and expires worthless. The worst-case outcome for an option holder is losing the premium. A $20 premium equals $2,000 ($20 x 100 multiple).
At 4,520, the contract is “in the money” by $20. If the holder exercises, the writer must deliver the intrinsic value in cash. Here, $20 “in the money” means a $2,000 cash payment ($20 x 100 multiple), which offsets the $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. Since the holder paid $2,000 to buy the option, the net profit is $3,000.
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 can see, index options behave much like equity options. You can use the same formulas from the long call chapter to answer questions like these.
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 option is “out of the money,” expires worthless, and the investor keeps the $1,500 ($15 x 100) premium.
A short put loses more as the market falls. If the RUT drops below 2,000, the contract goes “in the money” and gains intrinsic value.
Theoretically, the index could fall to zero, although this would be extremely unlikely (it would imply all 2,000 companies in the Russell 2000 went out of business).
A short put’s maximum loss is the strike price minus the premium (2,000 - 15). If the index were at zero, the option would be “in the money” by $1,985, producing a loss of $198,500 ($1,985 x 100).
At 1,985, the contract is “in the money” by $15. The holder would exercise, and the writer must deliver the intrinsic value in cash. A $15 intrinsic value means a $1,500 cash payment ($15 x 100), which offsets the $1,500 premium received.
At 2,040, the contract is “out of the money” and expires worthless. The investor keeps the $15 premium, for a $1,500 gain ($15 x 100).
At 1,960, the contract is “in the money” by $40. When assigned, the writer must deliver $4,000 ($40 x 100) to the holder. Since the writer received $1,500 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 questions like these.
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 that large 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 across sectors and geographic regions would likely have experienced substantial losses. When the economy was largely shut down, many businesses saw revenue decline at the same time. This is why investors cannot diversify out of market risk.
While you can’t diversify away market risk, you can hedge against it. As we learned in the hedging strategies chapter, one way to hedge is to buy (go long) an option that profits when the market moves against your portfolio.
For example, an investor with a large, diversified portfolio might buy (go long) index puts to 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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