Just like using common stock options, investors can use index options to profit from expected market movements or protect the underlying securities they own. The difference between the two is that the underlying securities in the latter are indices. These indices can be used to reflect the characteristics of the overall asset market as a whole or the characteristics of certain industries within the market.
Decentralization
Investors can use index options to gain access to the market as a whole or to certain specific sectors of the market. And this access requires only one buy or sell decision, and usually only one transaction. If you want to use individual stock or individual common stock options to obtain the same degree of diversification, you need to make a large number of decisions and transactions. Using index options can reduce the cost and complexity of these tasks.
Pre-determined risk for the buyer
The risk of index options is known to the buyer. The risk of other types of investments may be unlimited. The buyer of index options can never lose more than the price of the option, which is the premium.
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Leverage
Index options provide leverage. That is, the buyer of an index option only has to pay a small premium relative to the contract value to enter the market. The investor can gain a large percentage gain from a relatively small percentage change in the underlying index in a favorable direction. If the index does not move in the expected direction, the buyer’s risk is limited to the premium paid. However, because of the leverage, a small adverse market move can cause the buyer to lose a large amount or all of the premium. The writer of an index option is subject to far greater, even unlimited, risk.
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Guaranteed contract performance
The OCC’s rules and bylaws establish a system of brokers and clearing members involved in certain options transactions and certain funds established by the OCC to guarantee the performance of the contract. Option owners can rely on this system and these funds, rather than on a specific option writer, to guarantee the performance of the contract. Before the establishment of the options exchanges and the OCC, the option owner who wanted to exercise the option contract depended on the moral and financial level of his broker or option writer to guarantee the performance of the contract. In addition, there was no convenient way to close out the contract before it expired.
As the common clearing entity for all options on securities traded on U.S. exchanges, OCC resolves these issues. Once OCC determines that there are opposing orders from buyers and sellers, it separates the relationship between the two. OCC effectively becomes the buyer to the seller and the seller to the buyer. Thus, the seller can buy back the same option he wrote, closing out the original trade and canceling his obligation to OCC to deliver cash equal to the option exercise amount. This in no way affects the original buyer’s right to sell, hold or exercise his contract. All premium and settlement payments are paid to and by OCC.
