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An equity index option is an option whose underlying instrument is
intangible - an equity index. The market value of an index put and call
*tends to rise and fall in relation to the underlying index. The price of
an index call will generally increase as the level of its underlying index
increases, and its purchaser has unlimited profit potential tied to the
strength of these increases. The price of an index put will generally
increase as the level of its underlying index decreases, and its purchaser
has substantial profit potential tied to the strength of these decreases.
Pricing Factors
Generally, the factors that affect the price of an index option are the
same as those affecting the price of an equity option: value of the
underlying instrument (an index in this case), strike price, volatility,
time until expiration, interest rates and dividends paid by the component
securities.
Benefits of Listed Index Options
Like equity options, index options offer the investor an opportunity to
either capitalize on an expected market move or to protect holdings in the
underlying instruments. The difference is that the underlying instruments
are indexes. These indexes can reflect the characteristics of either the
broad equity market as a whole or specific industry sectors within the
marketplace.
Diversification
Index options enable investors to gain exposure to the market as a whole
or to specific segments of the market with one trading decision and
frequently with one transaction. To obtain the same level of
diversification using individual stock issues or individual equity option
classes, numerous decisions and transactions would be required. Employing
index options can defray both the costs and complexities of doing so.
Predetermined Risk for Buyer
Unlike other investments where the risks may have no limit, index options
offer a known risk to buyers. An index option buyer absolutely cannot lose
more than the price of the option, the premium.
Leverage
Index options can provide leverage. This means an index option buyer can
pay a relatively small premium for market exposure in relation to the
contract value. An investor can see large percentage gains from relatively
small, favorable percentage moves in the underlying index. If the index
does not move as anticipated, the buyer's risk is limited to the premium
paid. However, because of this leverage, a small adverse move in the
market can result in a substantial or complete loss of the buyer's
premium. Writers of index options can bear substantially greater, if not
unlimited, risk.
Strike Price
The strike price, or exercise price, of a cash-settled option is the
basis for determining the amount of cash, if any, that the option holder
is entitled to receive upon exercise. See Exercise Settlement for further
explanation.
In-the-money, At-the-money, Out-of-the-money
An index call option is in-the-money when its strike price is less than
the reported level of the underlying index. It is at-the-money when its
strike price is the same as the level of that index and out-of-the-money
when its strike price is greater than that level.
An index put option is in-the-money when its strike price is greater than
the reported level of the underlying index. It is at-the-money when its
strike price is the same as the level of that index and out-of-the-money
when its strike price is less than that level.
Premium
Premiums for index options are quoted like those for equity options, in
dollars and decimal amounts. An index option buyer will generally pay a
total of the quoted premium amount multiplied by $100 for the contract.
The writer, on the other hand, will receive and keep this amount.
The amount by which an index option is in-the-money is called its
intrinsic value. Any amount of premium in excess of intrinsic value is
called an option's time value. As with equity options, time value is
affected by changes in volatility, time until expiration, interest rates
and dividend amounts paid by the component securities of the underlying
index.
American vs. European Exercise
Although equity option contracts generally have only American-style
expirations, index options can have either American- or European-style.
In the case of an American-style option, the holder of the option has the
right to exercise it on or at any time before its expiration date.
Otherwise, the option will expire worthless and cease to exist as a
financial instrument. It follows that the writer of an American-style
option can be assigned at any time, either when or before the option
expires, although early assignment is not always predictable.
A European-style option is one that can only be exercised during a
specified period of time prior to its expiration. This period may vary
with different classes of index options. Likewise, the writer of a
European-style option can be assigned only during this exercise period.
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