What is an index?

A stock index is a grouping of several stock prices into one number. There are different types and sizes of indices. Some are broad-based, measuring broad and dispersed market movements. Others are narrow-based, measuring more specific sectors of the market. It is important to note that it is not the number of stocks that make up the average that determines whether an index is broad-based or narrow-based that determines whether it is broad-based or narrow-based, but rather the dispersion of the underlying securities and its market coverage. Different stock indices can be calculated in different ways. Accordingly, even indices based on the same securities will measure different markets because of their different calculation methods.

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.

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.

• The constituent securities of the index are being traded
• The prices of these securities are reported promptly
• The market prices of these securities, measured by the index, indicate price movements in the relevant markets.