Index Options

What are Index Options?

The index option is a derivative instrument that tracks 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 Option is one such example, where the underlying is based on 1/100th of the DJIA index, and the multiplier is $100.

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

Index Options

Components and Types of Index options

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

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 may have sector-specific indices that focus on industries like Information technology, healthcare, banking, etc. e.g., TSX composite bank index.

Index Option Example with Calculations

#1 – Pricing of an Index Option

Option pricing is the first and ideally the most complex one to do. Pricing means what premium an option buyer is required to pay upfront to assume the right to buy (or sell). Option Premium theoretically can be calculated using a replicating portfolio, using hedge ratios and binomial trees but more advanced methods like Black Scholes Merton pricing formula, Vanna Volga pricing, etc. are used in Financial Markets types.

The premium paid by 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 return, dividends, if any, etc.

The Black Scholes Merton pricing formula is expressed as below:

c = S0 N(d1) – Ke-rTN(d2)

p = Ke-rT N(-d2) – S0 N(-d1)

Where, d1 = ln(S0/K)+ (r+σ2/2)T / σ√T

d2 = ln(S0/K)+ (r+σ2/2)T / σ√T = d1- σ√T

Source: quantlabs.net

Where

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 basket of the index. To estimate the dividend component, individual stock’s dividend needs to be ascertained and weight them 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 on changing. Depending on that, either party can terminate the options contract by paying cancellation charges as agreed by both parties.

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

#3 – Payoff Calculation

Assume, Firm A need 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 on 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 maturity of 1 month.

Advantages of Index options

The following are the advantages of these 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 like indices, it becomes way too complex to price.

Conclusion

Index options can be used for hedging a portfolio of individual stocks or for speculating the future movement of the index. Investors can implement various option trading strategiesOption Trading StrategiesOptions Trading refers to a situation where the trader can purchase or sell a security at a particular rate within a specific period. Its strategies include Long Call Options, Short Call Options, Long Put Options, Short Put Options, Long Straddle Options, & Short Straddle Options etc. read more with index options viz. Bull spreads, 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 its definition. Here we discuss the types of index options, 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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