What are Index Options?

When stock options are exercised, the underlying stock is required to change hands. System response and access times may vary due to market conditions, system performance, and other factors.

Are all index options European style exercise?

Here's the bottom line with European style options. The buyer of the contract may not exercise early. What this means for a seller of options is that they don't have to worry about early assignment, a potential problem if a short position gets in the money.

Most but not all index options are European style. There are many others as well. A more complete list can be found here. Unlike most options, which cease trading on the third Friday and expire and settle on Saturday at noon, index options are quite a bit different. Failure to understand the difference between the two can be dangerous to your trading account.

Most index options cease trading on the close of business the third Thursday before the third Friday. Settlement value is calculated based on the Friday morning opening price of each of the components of the index. It is NOT based on the opening tick of the index on that Friday morning, although it may be roughly the same price. The settlement value for each of the indices won't typically be reported until several hours later. Why does this type of behavior pose potential problems?

Let me tell you what happened to one of my trades on the NDX. I had sold a short put spread that was doing very nicely although I hadn't reached my target closing price. Friday morning there was some news that caused a sharp sell-off and on the market open, NDX gapped down To make things worse, by mid morning, the market had recovered much of the gap down and the position would have expired out of the money had it settled on Saturday as most options do.

I learned 2 important lessons from this. Index options are cash settled. That means if an assignment were to take place, I wouldn't be forced to buy or sell the index depending on whether it's a put or call assignment. The profit potential for long index call options is unlimited, while the risk is limited to the premium amount paid for the option, regardless of the index level at expiration.

For long index put options, the risk is also limited to the premium paid, and the potential profit is capped at the index level, less the premium paid, as the index can never go below zero. Beyond potentially profiting from general index level movements, index options can be used to diversify a portfolio when an investor is unwilling to invest directly in the index's underlying stocks.

Index options can also be used in multiple ways to hedge specific risks in a portfolio. American -style index options can be exercised at any time before the expiration date, while European-style index options can only be exercised on the expiration date. Imagine a hypothetical index called Index X, which has a level of Assume an investor decides to purchase a call option on Index X with a strike price of With index options, the contract has a multiplier that determines the overall price.

Usually the multiplier is It is important to note the underlying asset in this contract is not any individual stock or set of stocks but rather the cash level of the index adjusted by the multiplier. While trading options can help minimize risk related losses with index funds, index options can be utilized as their own separate investment. When trading any kind of options, including index options, investors have the choice between a call and put strategy.

A call option, with respect to indexes, allows the investor to buy a basket of stocks at a predetermined price with the expectation that the value of the index will rise. Conversely, a put option gives the investor the right to sell an index at a predetermined strike price. Under this assumption the investor believes the value of the index will decrease.

When utilizing options the investor is not buying or selling the physical stock index; however, the value of the option will move in the same direction as the market index. Buying an index call is a bullish strategy as the value of the call option increases as the value of the underlying index rises. Conversely, buying an index put is a bearish strategy. The value of the put increases as the value of the underlying asset decreases.

Profit potential in both cases is limited to the underlying index increasing or decreasing to the strike price.

The financial risks for call and put options are limited to the total premium paid for the option. Buying put and call indexes are basic strategies in index option trading, with more advanced strategies including straddle and collars.

An index straddle is an option strategy which involves purchasing both an index call and index put with both options having the same strike price.