An index position uses a defined metric and technique to quantify the price performance of a basket of assets. In the financial markets, indexes are frequently employ benchmarks against which an investment’s performance measured.
What Is an Index Position Option?
An Index position option is a financial derivative that allows the holder to purchase or sell the value of an underlying index. Such as the S&P 500 index, at the set exercise price. There are no actual stocks purchase or trade. An index option’s underlying asset is frequently an index futures contract. Index options always cash-settled and are primarily European-style options. Which means they only settle on the maturity date and do not allow for early exercise.
How does it work?
Index call and put options are common ways to trade. The broad direction of an underlying index while risking relatively little money. Index call options provide an unlimited profit potential.
But the risk is limit to the price paid for the option. Because the index can never go below zero, the risk is likewise restrict to the premium paid. While the possible profit capped at the index level, minus the premium paid.
Index options used to diversify a portfolio when an investor is hesitant to invest directly in the index’s underlying equities, in addition to possibly gaining from overall index level fluctuations.
Index options used to protect a portfolio from certain risks. While American-style options exercised at any time prior to expiration, index options are typically European-style and can only be executed on the expiration date.
Instead of directly tracking an index, most index options use an index futures contract as the underlying investment. Because futures contracts are derivatives of the index. An option on an S&P 500 futures contract thought of as a second derivative of the index.
As a result, there are more factors to consider because both the option and the futures contract have their own risk/reward profiles and expiry dates.
The contract has a multiplier that determines the overall premium, or price paid, for such index options. The multiplier is usually set at 100. The S&P 500, on the other hand, has a 250x multiplier.
Example of an Index Option
Consider the case of Index X, a hypothetical index with a present level of 500. Consider the case where an investor decides to buy a call option on Index X with a strike price of 505. If this 505 call option costs $11, the entire contract will cost $1,100, or $11 multiplied by 100.
It’s vital to understand that the underlying asset in this contract is the cash level of the index adjusted by the multiplier, not any specific stock or collection of companies. It’s $50,000 in this case, or $500 multiplied by $100.
An investor can buy the option for $1,100 instead of investing $50,000 in the index’s equities and use the remaining $48,900 elsewhere.
This trade has a maximum risk of $1,100. The strike price plus the premium paid is the break-even point for an index call option trade. That’s 516 in this case, or 505 plus 11. This specific trade gets lucrative at any level over 516.
If the index level at expiry is 530, the call option owner would exercise it and get $2,500 in cash from the opposing side of the deal, or (530 – 505) x $100. This deal makes a profit of $1,400 after deducting the original price.
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