What is Index Options Trading: A Complete Guide
Investors interested in trading options can choose from a range of options products, including equity options, bond options, index options, and more.
Index options have increased in popularity over the years. One of the many reasons that investors may trade them is because they offer an opportunity to trade based on a directional bias of the market, whether they're bearish, bullish or neutral. But there's more to know about index options, including their cash settlement. Read on to learn more.
What are index options
An index option is a type of financial derivative that grants the holder the right, but not the obligation, to buy or sell the value of a specified underlying index—such as the S&P 500 index—at a predetermined exercise price. Index options are typically European-style options, which means they settle only at the expiration date and they are also cash settled.
Cash settled means it's not required to take physical delivery of the underlying asset or security. The settlement comes from a cash payment vs settling in the underlying security such as a stock, bond, or commodity.
How do index options work
Index options provide investors with the ability to speculate on the performance of a broad market index or specific market sector, rather than individual stocks. These options derive their value from underlying indices including the S&P 500, NASDAQ-100, or Dow Jones Industrial Average. When trading index options, investors can cost-effectively gain exposure to the overall market or specific segments, which helps in potentially diversifying their investment portfolio with a single transaction.
Index options can be used for various investment strategies including hedging, speculating, or income generation. Hedging with index options can potentially help investors manage risk in their portfolios against market downturns by purchasing put options. Call options can be bought to speculate on anticipated market upswings and writing (selling) index options can generate income.
When an option seller (writer) is assigned on a contract, they are required to meet the contract's obligations. For example, if the price of the underlying asset trades below the strike price before or at expiration, they may be obligated to buy the asset at the strike price.
Example of index options trading
An investor buys a call option on the S&P 500 index with a strike price of 4,020, which is 0.5% higher than the current trading price of 4,000. The contract has a multiplier of 100, so if the option is priced at $10, the investor would need to pay $1,000. The call option may profit if the index closes above the strike price on the expiration day.
Learn more about 0DTE options here>>
Options strategies for index options trading
There are many different strategies when trading index options, from beginner level, such as the long call and long put to more advanced strategies including strangles and straddles. Depending on an investor's experience, investment goals, and market sentiment, this can help them explore which strategy to use. Regardless of which one is selected, it's important to understand that options carry risks.
Long call
A long call index option trade is a bullish strategy that gives the buyer the right to participate in the underlying index's potential increases above the strike price until the option expires. The buyer pays a premium for this right. Index options cannot be settled with shares; they are cash settled.
The underlying instrument of an equity option is a number of shares of a specific stock, usually 100 shares. Cash-settled index options do not correspond to a particular number of shares. Rather, the underlying instrument of an index option is usually the value of the underlying index of stocks times a multiplier, which is generally $100.
Long put
A long put option index trade is a bearish strategy that gives the buyer the right to participate in the underlying index's potential declines below the strike price until the option expires. The buyer (option holder), pays a premium to acquire this right. Instead of buying put options for each individual stock, investors may buy put options on the stock index. This can potentially help offset some portfolio loss, if the put option positions gain value if the stock index declines.
Straddle and Strangle
For a short strangle, this involves simultaneously selling a call with a higher strike price and a put with a lower strike price. For example, when the index is trading at 7300, an investor might sell an August 6700 Put at 77 and an August 7700 Call at $33. If the index trades between 6700 and 7700 at expiration, both options expire worthless and the investor retains the maximum profit.
For a straddle, this strategy involves simultaneously purchasing or selling both a call option and a put open with the same strike price and expiration date for a particular underlying index. If the call and put are both purchased, the associated trade structure is called a “long straddle” but a "short straddle" occurs if the call and put are both sold. For example, a long straddle with an index trading at 7300, an investor could buy an August 7300 call and buy an August 7300 put at $33.
Covered Call
A covered call strategy involves pairing a long position (owning the underlying security) with a short call option on the same security. For the long call option, you own a specific amount of an underlying asset (the index) and the short call option, you sell a call option on the same index. The combination of these two positions can lead to higher returns and lower volatility compared to just holding the underlying index.
Protective Put
A protective put index options strategy involves holding a long position in an index or an index-based portfolio while purchasing put options on the same index. This approach acts as a form of insurance, providing downside protection against significant losses in a declining market. The strategy can limit losses and establish a floor price, while still allowing for potentially unlimited upside.
When implementing a protective put strategy, an investor first acquires a portfolio that reflects a broad market index, such as the S&P 500. To hedge against potential declines, the investor then buys put options on that index. If the market value of the index drops below the put option's strike price, the investor can exercise the option, effectively selling the index position at the higher strike price. This maneuver helps to offset the losses in the portfolio, as the put option's value will increase while the index value decreases.
How to access and trade U.S. index options using moomoo
Moomoo provides a user-friendly platform for trading options. Here's a step-by-step guide:
Step 1: Open the moomoo app and search for an index that you're interested in. Let's use SPX as an example for illustrative purposes.
Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
Step 2: Go to the Market's page (1), click on Options (2), select Index to see an overview of index options and information on popular indices, option rankings, and more (3).
Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
Step 3: Tap on your desired index option to enter its detailed quotes page for trading. Then you can use features such as Analysis and Unusual Activities to help you make more informed decisions.
Disclaimer: Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
The steps for entering a trade for index options are the same as stock options. On the options chain page, select Call or Put, choose a trading strategy, select an expiration date and price, and tap on the trade button to place your order.
Advantages and risks of index options trading
Index trading comes with both risk and advantages that investors should take into consideration.
● Diversification: Enables investors to gain market-wide or specific sector exposure through a single trading decision, often with a single transaction. This may help reduce costs and complexities for investors.
● Leverage: Pays (an option buyer) a relatively small premium to gain broader market exposure in relation to the contract value. This can lead to larger percentage gains from small, favorable percentage moves in the underlying index. If the index does not move as anticipated, the buyer's risk is generally confined to the premium paid. However, due to the leverage involved, even a minor adverse movement in the market can lead to a substantial or complete loss of the buyer's premium. Index options writers face significantly greater risk, potentially unlimited, depending on market fluctuations.
● Predetermined maximum loss: Buyer's potential theoretical max loss is limited to the options purchase price (the premium).
● Market volatility: Index options are sensitive to market volatility, which can increase both potential gains and losses.
● Time decay (theta): Index options contracts have a predetermined time frame for exercise, and their value decreases as they approach expiration. If the index doesn't move as expected, the option holder may lose money if they are holding a long position.
● Complexity: Options trading can be complex and requires understanding various strategies before participating.
Index Options vs Stock Options: What's the difference
Besides their different underlying assets, index options and stock options have additional differences. To learn more, read this moomoo views article, Index Options vs. Equity Options: 5 Key Differences.
Equity Options Exercise (American style) | Index Options Exercise (European Style) |
Exercised at any time before expiration | Cannot be exercised prior to the expiration date |
Expire on the third Friday of the month (Varies) | Expire on the third Thursday of the month (Varies) |
Settled on the following day, Saturday (Varies) | Settled on the following day, Friday (Varies) |
Underlying stock transferred | Cash settled |
FAQs about index options
What are the most popular index options?
Popular index options available on U.S. exchanges include the following: NASDAQ 100 Index ($NDX), S&P 500 Index ($SPX), Russell 2000 Index ($RUT), Dow Jones Industrial Average 1/100 Index ($DJX), S&P 100 index ($OEX), S&P 500 Volatility Index ($VIX)and S&P 100 (European) Index ($XEO).
How many index options are there?
As for U.S. markets, the pool of index options is small but it's constantly evolving as exchanges are launching new ones to trade. The most prominent index options include the S&P 500 (SPX) options, which offers broad representation of the U.S. stock market as well as additional index options including the Nasdaq-100 (NDX) options, Russell 2000 (RUT) options, and Dow Jones Industrial Average (DJX) options.
Why consider using index options?
There are many reasons to consider using index options. This can include helping investors to speculate on the market's direction, potentially generating income and hedging for some potential downside protection on a portfolio of stocks.
