Index Options Strategies Explained – Binary Trading Library
Trading index options is one way to participate in the stock market.
1 Explain Derivatives in the Stock Market
3 Value of a Stock Option
4 Exercising Stock Options Vs. Selling on the Open Market
Index options are financial contracts whose value is derived from a stock market index. An index is an average of many stock prices. For example, the Dow Jones Industrial Average index is an average of 30 stock prices in the American stock market. Index options are similar in structure to stock options and provide traders with a diverse set of speculative strategies that are otherwise not available in stock transactions. You can trade options on over 40 different stock market indexes.
All options, whether they are stock options or index options, are contracts that trade in the public markets. These contracts provide specific terms for the prediction of future prices. The three primary components of any option are the contract’s expiration date, the “strike price” of the option, and the directionality of the option. A strike price is the price which the index must meet by its expiration for the option to have any value. The directionality of the option specifies whether it profits from a rise, or a fall, in the index’s value.
There are two main types of index options: “calls” and “puts.” A call option increases in value as the index rises, while a put option rises in value as the index falls. It is thus possible to profit from either market condition using index options. Particularly novel strategies use both calls and puts in a single transaction to profit from other market conditions, such as “flat” markets that do not rise or fall significantly.
Stock options control actual shares of stock. However index options, while structured similarly, cannot control shares of stock because a stock market index is not a tangible entity. Rather, it is an average price of many stocks. Since you cannot purchase shares of an index, index options are “cash settled.” This means that rather than actual shares of stock changing hands due to the terms of the option contract, cash is transferred between the buyer and seller at the option’s expiration. The amount of this cash is based on the option’s terms and the level of the index at the time of expiration.
Index options are one way to leverage the movement in a stock market index. “Leverage” means that the profit or loss from the option’s price changes are significantly greater than the profit or loss from the purchase of regular shares of stock. For this reason, index options are very risky. It is possible for their value to fluctuate by hundreds of percent in just a few days.
If you believe a stock market index, such as the S&P 500 or the Dow, is going to rise significantly, you can purchase a “call” option. If you are correct, this index option will rise in value as the index rises. Likewise the put will rise if the index declines. However, if you purchase both a call and a put together, this strategy (called a “straddle”) offers profit potential if the index moves in either direction. One of the options will lose most of its value but the profit from the other will often overwhelm this loss and result in a net profit for the pair. With any index option strategy, you may sell the options before their expiration for a profit or loss.