## What are Index Options?

The index option is a derivative instrument that tracks the performances of the entire index and gives the right to buy (or sell) units of an index at a contracted rate on a certain future date.

Dow Jones Index Optionis one example, where the underlying is based on 1/100th of the DJIA index, and the multiplier is $100.

##### Table of contents

### Key Takeaways

- Index options allow buying or selling units of a whole index at a set price on a future date. Dow Jones Index Option is based on 1/100th of the DJIA index with a $100 multiplier.
- To calculate option premiums, we consider factors like spot price, strike price, days until expiration, stock price volatility, risk-free rate of return, and dividends. These determine the premium paid option buyer.
- Investors can use index options to hedge a stock portfolio or speculate on the index’s future. Various strategies include bull/bear spreads, covered calls, and protective puts. These strategies may reduce profits but also lower risks.

The most common examples of index options include (but are not restricted to):

- S&P 500 and SPX
- DJX – Dow Jones Index
- IWB – iShares Russell 1000® Index Fund
- NDX – Nasdaq-100
- OEX – SP100 Index
- QQQ – Options on Nasdaq-100 Index Tracking Stock
- RMN – Mini-Russell 2000®
- RVX – CBOE Russell 2000® Volatility Index Options Index

### Components and Types of Index options

Just like any vanilla option, Index options are characterized by:

- An underlying index
- The strike price of the optionStrike Price Of The OptionExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more
- The maturity/ expiry date of the option
- Whether it’s a put or a call optionCall OptionA call option is a financial contract that permits but does not obligate a buyer to purchase an underlying asset at a predetermined (strike) price within a specific period (expiration).read more

The underlying index is what differentiates one option from others, e.g., an option contract on S&P 500 will give an option buyer the right to buy (or sell) certain units (as earlier agreed upon in the contract) of the S&P index and the option writer will have to sell (or buy). Index options may have broad-based indices such as S&P or the Dow Jones or sector-specific indices that focus on industries like Information technology, healthcare, banking, etc., e.g., TSX composite bank index.

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### Index Option Example with Calculations

#### #1 – Pricing of an Index Option

Option pricingOption PricingOption pricing refers to the process of determining the theoretical value of an options contract. read more is the first and, ideally, the most complex. Pricing means the premium an option buyer must pay upfront to assume the right to buy (or sell). Option Premium theoretically can be calculated using a replicating portfolio, hedge ratiosHedge RatiosThe hedge ratio is the open position's hedge ratio's comparative value with the position's aggregate size itself. Also, it can be the comparative value of the futures contracts purchased or sold with a value of cash commodity that is being hedged.read more, and binomial trees. Still, more advanced methods like Black Scholes Merton pricing formula, Vanna Volga pricing, etc. are used in Financial Markets typesFinancial Markets TypesThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more.

The premium paid by the option buyer is calculated using various methods. The common inputs for Option Premium calculations are Spot Price, Strike Price, Days to expiry, Volatility of Stock price, Risk-free rate of returnRisk-free Rate Of ReturnA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk.read more, dividends, if any, etc.

The Black Scholes Merton pricing formula is expressed as below:

**c = S _{0} N(d_{1}) – Ke^{-rT}N(d_{2})**

**p = Ke ^{-rT} N(-d_{2}) – S_{0} N(-d_{1})**

Where, **d _{1} = ln(S_{0}/K)+ (r+σ^{2}/2)T / σ√T**

**d _{2} = ln(S_{0}/K)+ (r+σ^{2}/2)T / σ√T = d1- σ√T**

Source: quantlabs.net

Where

**c:**Premium/ price of the call option**p:**Premium/ price of the put optionPut OptionPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated.read more**S**Spot priceSpot PriceSpot Rate' is the cash rate at which an immediate transaction and/or settlement takes place between the buyer and seller parties. This rate can be considered for any and all types of products prevalent in the market ranging from consumer products to real estate to capital markets. It gives the immediate value of the product being transacted.read more_{0}:**K:**Strike price**N(d**Probability distributionProbability DistributionProbability distribution could be defined as the table or equations showing respective probabilities of different possible outcomes of a defined event or scenario. In simple words, its calculation shows the possible outcome of an event with the relative possibility of occurrence or non-occurrence as required.read more of Spot (Delta of the option)_{1}):**N(d**Probability distribution of forward price movement_{2}):**T:**time to expiry**r:**Risk-free rate of return**σ:**Estimated volatility

The Vanna-Volga pricing model takes BSM one step further and adjusts the above formula for risks associated with volatility.

The main problem associated with the above models in pricing the index options is how to account for the dividends associated with different stocks in the index basket. To estimate the dividend component, individual stock’s dividend needs to be ascertained and weighted in proportion to each stock in the index. Another way is to use dividend yieldDividend YieldDividend yield ratio is the ratio of a company's current dividend to its current share price. It represents the potential return on investment for a given stock.read more published by data sources like Bloomberg.

#### #2 – Valuation or Mark to Market of an Ongoing Option Contract

The Value of the Call Option to the buyer (Or seller) after the contract till expiry keeps changing. Depending on that, either party can terminate the options contract by paying cancellation charges as agreed.

The calculation involved in Valuation is similar to the pricing of the option. Parameters such as volatility and time to risk-free expiry rate of return keep changing depending on how financial markets work.

#### #3 – Payoff Calculation

Assume that Firm A needs to invest in the Dow Jones index (DJX) after one month. Currently, Dow Jones trades at $267. Firm A is bullish on Dow Jones and believes the DJX will trade at $290 basis the analysis of financial data in the market. Another Firm, B, is bearishBearishBearish market refers to an opinion where the stock market is likely to go down or correct shortly. It is predicted in consideration of events that are happening or are bound to happen which would drag down the prices of the stocks in the market.read more on the DJX and believes DJX will stay below $265.

The two firms will then formally enter into a Call option Contract with a Strike Price of $265 and a maturity of 1 month.

- Firm A will belong to the Call option contract and thus will have the right to buy units of DJX from Firm B for $265, even if the Shares of ABC are trading at $290.
- To get this right to buy, Firm A will have to pay some upfront amount known as Option Premium.
- Firm A will not be obliged to buy units of DJX if the price is less than the strike price of $265, thereby having downside riskDownside RiskDownside Risk is a statistical measure to calculate the loss in a security’s value due to variations in the market conditions. Also, it refers to the uncertainty level of realized returns being much lesser than the anticipated ones. read more.
- Firm B will be short on the Call option contract and have to sell the units of DJX irrespective of what rate DJX is trading at.
- The contract expires after a fixed expiry date, i.e., 1 Month

The concept can be explained using the below given chart, where there is a profit booking during fall in the index. Thus, in case of a bear market, an option strategy can be used comfortably to earn profit. But there is also the possibility to lose the entire investment. The strike price is assumed to be $195, with a premium of $3.90 for each contract.

Therefore, this is a long-put option which will earn profit only when the market will go down. Now if we assume that the index has gone down to $192, still the option has not even reached the breakeven. It will reach the breakeven only when the index goes below $191.10, which includes the strike price plus the premium. The lower the index moves, the higher is the profit for the trader. This is how the index option works.

### Advantages of Index options

The following are the advantages of these options.

**Diversification**: Index options are based on a large basket of stocks. This gives an easy diversification alternative to the investors.**Volatility**: Index options are less volatile, hence easier to predict.**Liquidity**: Since Index options are popular among traders, hedge fundsHedge FundsA hedge fund is an aggressively invested portfolio made through pooling of various investors and institutional investor’s fund. It supports various assets providing high returns in exchange for higher risk through multiple risk management and hedging techniques.read more, and investment firms, the volume available for trading is enough to keep the bid-ask spread in check, and prices are very close to a fair price.**Cash****Settlements**: Index options are cash-settled. This makes settlements easier than the actual delivery of stocks in stock options.- Relatively low-cost investment alternative to buying individual stock options.

### Disadvantages of Index Options

Below are the limitations of Index options.

- Index options being a little less rewarding, may not be attractive for investors who are willing to take on higher risks for more rewards.
- The pricing models for options are very complex, and to account for underlying indices, it becomes way too complex to price.

### Frequently Asked Questions (FAQs)

**How do index options differ from stock options?**

Whereas stock options are based on a single company’s shares, index options are based on a basket of equities reflecting either a large or a small band of the total market.

**Are index options European style?**

Index options are of the European kind, which prevents early exercise. On the other hand, equity options are always exercisable. While index options settle to cash, stock options agree to shares of the underlying stock.

**What is the role of implied volatility in index options?**

Implied volatility represents market expectations for future price fluctuations. Higher implied volatility usually leads to higher option premiums and vice versa. Traders often consider implied volatility when evaluating potential option trades.

**Are index options regulated?**

Yes, index options are regulated financial instruments and are traded on organized options exchanges. Regulatory bodies oversee these exchanges to ensure fair and transparent trading practices.

### Conclusion

Index options can be used for hedgingHedgingHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market.read more a portfolio of individual stocks or speculating the index’s future movement. Investors can implement various option trading strategiesOption Trading StrategiesOptions trading refers to a contract between the buyer and the seller, where the option holder bets on the future price of an underlying security or index.read more with index options viz. Bull spreadsBull SpreadsA bull spread is a widely used two leg option trading strategy that involves buying and selling the option contracts of equal quantity of any financial asset having the same expiration but different strikes such that the strategy delivers a profit in bullish movement.read more, bear spreadsBear SpreadsBear Spread is the price spread where you buy either call or put options at different Strike Prices having the same expiration date. It is used when an investor believes that a stock price will go down, but not drastically.read more, covered calls, protective puts. These strategies may lead to lesser profits, but the risk is minimized greatly.

### Recommended Articles

This has been a guide to What is Index Options and their definition. Here we discuss the types of index options and how it is priced, along with calculation examples, advantages, and disadvantages. You can learn more about derivatives from the following articles –

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