The underlying security of common stock index options is not the physical asset, but the security index. The market prices of index put and call options tend to rise and fall with the underlying index. The price of index call options usually rises as the underlying index rises. Its buyer has unlimited potential profit. This profit depends on the strength of this rise. The price of index put options usually rises as the underlying index falls. Its buyer has huge potential profit. This profit depends on the strength of this fall.
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.
Ads-ADVERTISEMENT
Ads-ADVERTISEMENT
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.
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.
Cash Settlement
Common stock options differ from index options primarily in the underlying instrument and settlement method. Generally speaking, cash changes hands when an index option owner exercises the contract and when an index option writer is assigned. Only a pre-specified amount of cash is transferred from an investor assigned to a written contract to an investor exercising the contract he or she purchased. This is called a cash transaction.
Right to Purchase
Purchasing an index option does not entitle the investor to buy or sell all the stocks included in the underlying index. Because the index is just a non-physical representation of a number, you can think of buying an index option as buying a value that changes with market sentiment and price fluctuations. Investors who purchase index options obtain certain rights as specified in the terms of the contract. Generally speaking, this includes demanding and receiving a specified amount of cash from the writer who sold the same contract.
Option Types
The current strike price, expiration month and last trading day for each index option type vary by option type. Option types are all option contracts of the same class (calls and puts) and type (American, European or capped) based on the same underlying index. If you want to know the contract terms of the option type you want to use, please contact the exchange or options industry association that conducts the option trading.
Strike Price
The exercise price, or strike price, of a cash-settled option is the basis for determining the cash (if any) that the option holder is entitled to receive upon exercise. See the Exercise Settlement section for more details.
Premium, parity, loss
When the strike price of an index call option is lower than the reported value of the underlying index, the option is in-the-money. When its strike price is equal to the value of the index, it is at-the-money. When its strike price is higher than the index value, it is out-of-the-money.
When the strike price of an index put option is higher than the reported value of the underlying index, the option is in-the-money. When its strike price is equal to the value of the index, it is at-the-money. When its strike price is lower than the index value, it is out-of-the-money.
Premium
Index option premiums are quoted in the same way as common stock options, expressed in whole and decimal dollars. The amount that an index option buyer pays for the contract is usually the quoted premium multiplied by $100.
The amount by which an index option becomes premium is called the intrinsic value. Any amount of the premium that exceeds the intrinsic value is called the time value of the option. As with common stock options, time value is affected by volatility, the time remaining until expiration, interest rates, and the amount of dividends paid by the constituent securities of the underlying index.
Performance and Assignment
The exercise settlement value is the value of the index used to calculate how much cash (the exercise settlement amount) will change hands when an index option is exercised before or on the expiration date. The value of each index underlying an option, including the exercise settlement value, is the value of the index determined by the quotation agency designated by the market where the option is traded. Unless otherwise directed by the Options Clearing Corporation, the values determined by the quotation agency are believed to be accurate and are considered to be the final values used to calculate the exercise settlement amount.
To ensure that an index option is exercised on a certain day before the expiration date, the owner must notify the brokerage firm before the exercise deadline for the brokerage firm to accept exercise notices on that day. On the expiration date, the exercise deadline may be different from the deadline for early exercise before the expiration date. Note: Different firms have different deadlines for accepting exercise notices from their customers. These deadlines may vary depending on the type of option. In addition, the expiration time for index options may be different from the expiration time for common stock options.
After the Options Clearing Corporation receives an exercise notice, it assigns it to one or more clearing members with short positions in the same series according to established procedures. The clearing member also assigns it to one or more of its customers with short positions in the same series. The assignment can be random or first-in, first-out. After being assigned an exercise notice, the index option writer is obligated to pay the amount in cash. Settlement and subsequent cash transfer usually occurs on the next business day after the exercise.
NOTE: Most firms require their clients to notify their intent to exercise on the expiration date, even if the option is in-the-money. You should ask your firm to explain in detail its exercise procedures, including any exercise notice deadline your firm may have on the last trading day prior to the expiration date.
Morning and afternoon settlement
There are different ways that quotation agencies determine the exercise settlement value of common stock index options. The two most common methods are:
Afternoon Settlement: The settlement value is the index value reported on the execution date. This index value is calculated based on the last reported price of the constituent stocks in the index at the close of the market on that day.
Morning settlement: The settlement value is the index value reported on the performance date. This index value is calculated based on the market opening prices of the constituent stocks in the index on that day.
Ads-ADVERTISEMENT
Ads-ADVERTISEMENT
If a component security is not trading at the open on the day the exercise settlement value is determined, the last reported price for that security will be used.
Investors should be aware that index option exercise settlement prices derived from the opening prices of the component securities may not be reported until several hours after those securities begin trading. Some updated index values may be reported at and after the opening. This reporting is before the exercise settlement values are reported. There may be significant differences between those reported index values and the reported exercise settlement values.
American and European fulfillment
While common stock options contracts typically have only American-style expirations, index options can have both American-style and European-style expirations.
In the case of an American option, the option owner has the right to exercise the option at any time before or on the expiration date. Otherwise, the option expires worthless and ceases to exist as a financial instrument. Similarly, the writer of an American option can be assigned at any time on or before the expiration date, although early assignment is not always possible.
European options can only be exercised within a specific time frame before expiration. This time frame varies with the type of index option. Likewise, the writer of a European option can only be assigned within this exercise time frame.
Performance Settlement
The amount of cash received when an index option is exercised or when it expires depends on the closing value of the underlying index relative to the strike price of the index option. The amount of cash that changes hands is called the exercise settlement amount. This amount is calculated by taking the difference between the option’s strike price and the underlying index value reported as the exercise settlement amount (i.e., the option’s intrinsic value), and multiplying it by $100. This calculation applies whether the option is exercised before or on the expiration date.
In the case of a call option, if the underlying index value is above the strike price, the option owner will exercise the option and receive the exercise settlement amount. For example, if the reported index settlement value is 79.55, the owner of a long 78 strike call option will exercise and receive $155 [(79.55 – 78) x $100 = $155]. The option writer will deliver this amount to the option owner.
In the case of a put option, if the underlying index value is below the strike price, the option owner will exercise the option and receive the exercise settlement amount. For example, if the reported index settlement value is 74.88, the owner of a long 78 strike put option will exercise and receive $312 [(78 – 74.88) x $100 = $312]. The option writer will deliver this amount to the option owner.
Closing a trade
As with common stock options, an index option writer who wishes to close out his position purchases a contract of the same terms from the market. To avoid being assigned and the obligations inherent therein, the option writer must buy the contract before the close of trading on a given day to avoid receiving an assignment notice on the next business day. To close out a long position, the purchaser of an index option can either sell the contract in the market or exercise it if it is advantageous.
