What is an Index?
A stock index is a compilation of several stock prices into a single number. Indexes
come in various shapes and sizes. Some are broad-based and measure moves in broad,
diverse markets. Others are narrow-based and measure more specific industry sectors
of the marketplace. Understand that it is not the number of stocks that comprise
the average that determine if an index is broad-based or narrow-based, but rather
the diversity of the underlying securities and their market coverage. Different
stock indexes can be calculated in different ways. Accordingly, even where indexes
are based on identical securities, they may measure the relevant market differently
because of differences in methods of calculation.
Capitalization-Weighted
An index can be constructed so that weightings are biased toward the securities
of larger companies, a method of calculation known as capitalization-weighted. In
calculating the index value, the market price of each component security is multiplied
by the number of shares outstanding. This will allow a security's size and capitalization
to have a greater impact on the value of the index.
Equal Dollar-Weighted
Another type of index is known as equal dollar-weighted and assumes an equal number
of shares of each component stock. This index is calculated by establishing an aggregate
market value for every component security of the index and then determining the
number of shares of each security by dividing this aggregate market value by the
current market price of the security. This method of calculation does not give more
weight to price changes of the more highly capitalized component securities.
Other Types
An index can also be a simple average: calculated by simply adding up the prices
of the securities in the index and dividing by the number of securities, disregarding
numbers of shares outstanding. Another type measures daily percentage movements
of prices by averaging the percentage price changes of all securities included in
the index.
Adjustments & Accuracy
Securities may be dropped from an index because of events such as mergers and liquidations
or because a particular security is no longer thought to be representative of the
types of stocks constituting the index. Securities may also be added to an index
from time to time. Adjustments to indexes might be made because of such substitutions
or due to the issuance of new stock by a component security. Such adjustments and
other similar changes are within the discretion of the publisher of the index and
will not ordinarily cause any adjustment in the terms of outstanding index options.
However, an adjustment panel has authority to make adjustments if the publisher
of the underlying index makes a change in the index's composition or method of calculation
that, in the panel's determination, may cause significant discontinuity in the index
level.
Finally, an equity index will be accurate only to the extent that:
- the component securities in the index are being traded.
- the prices of these securities are being promptly reported.
- the market prices of these securities, as measured by the index, reflect price movements
in the relevant markets.
Benefits of Listed Index Options
Like equity options, index options offer the investor an opportunity
to either capitalize on an expected market move or to protect holdings in the underlying
instruments. The difference is that the underlying instruments are indexes. These
indexes can reflect the characteristics of either the broad equity market as a whole
or specific industry sectors within the marketplace.
Diversification
Index options enable investors to gain exposure to the market as a whole or to specific
segments of the market with one trading decision and frequently with one transaction.
To obtain the same level of diversification using individual stock issues or individual
equity option classes, numerous decisions and transactions would be required. Employing
index options can defray both the costs and complexities of doing so.
Predetermined Risk for Buyer
Unlike other investments where the risks may have no limit, index options offer
a known risk to buyers. An index option buyer absolutely cannot lose more than the
price of the option, the premium.
Leverage
Index options can provide leverage. This means an index option buyer can pay a relatively
small premium for market exposure in relation to the contract value. An investor
can see large percentage gains from relatively small, favorable percentage moves
in the underlying index. If the index does not move as anticipated, the buyer's
risk is limited to the premium paid. However, because of this leverage, a small
adverse move in the market can result in a substantial or complete loss of the buyer's
premium. Writers of index options can bear substantially greater, if not unlimited,
risk.
Guaranteed Contract Performance
An option holder is able to look to the system created by
OCC's Rules and By-Laws (which includes the brokers and Clearing Members
involved in a particular option transaction) and to certain funds held by OCC rather
than to any particular option writer for performance. Prior to the existence of
option exchanges and OCC, an option holder who wanted to exercise an option depended
on the ethical and financial integrity of the writer or his brokerage firm for performance.
Furthermore, there was no convenient means of closing out one's position prior to
the expiration of the contract.
As the common clearing entity for all U.S. exchange-traded securities option transactions,
OCC resolves these difficulties. Once OCC is satisfied that there are matching orders
from a buyer and a seller, it severs the link between the parties. In effect, OCC
becomes the buyer to the seller and the seller to the buyer. As a result, the seller
can buy back the same option he has written, closing out the initial transaction
and terminating his obligation to deliver cash equal to the exercise amount of the
option to OCC. This will in no way affect the right of the original buyer to sell,
hold or exercise his option. All premium and settlement payments are made to and
paid by OCC.
Equity vs. Index Options
An equity index option is an option whose underlying instrument
is intangible - an equity index. The market value of an index put
and call tends to rise and fall in relation to the underlying index.
The price of an index call will generally increase as the level of its underlying
index increases, and its purchaser has unlimited profit potential tied to the strength
of these increases. The price of an index put will generally increase as the level
of its underlying index decreases, and its purchaser has substantial profit potential
tied to the strength of these decreases.
Pricing Factors
Generally, the factors that affect the price of an index option are the same as
those affecting the price of an equity option: value of the underlying instrument
(an index in this case), strike price, volatility, time until expiration, interest
rates and dividends paid by the component securities.
Underlying Instrument
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 relate 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
U.S. $100.
Volatility
Indexes, by their nature, are less volatile than their individual component stocks.
The up and down movements of component stock prices tend to cancel one another out,
lessening the volatility of the index as a whole. However, the volatility of an
index can be influenced by factors more general than can affect individual equities.
These can range from investors' expectations of changes in inflation, unemployment,
interest rates or other economic indicators issued by the government and political
for military situations.
Risk
As with an equity option, an index option buyer's risk is limited to the amount
of the premium paid for the option. The premium received and kept by the index option
writer is the maximum profit a writer can realize from the sale of the option. However,
the loss potential from writing an uncovered index option is generally unlimited.
Any investor considering writing index options should recognize that there are significant
risks involved.
Cash Settlement
The differences between equity and index options occur primarily in the underlying
instrument and the method of settlement. Generally, when an index option is exercised
by its holder, and when an index option writer is assigned, cash changes hands.
Only a representative amount of cash changes hands from the investor who is assigned
on a written contract to the investor who exercises his purchased contract. This
is known as cash settlement.
Purchasing Rights
Purchasing an index option does not give the investor the right to purchase or sell
all of the stocks that are contained in the underlying index. Because an index is
simply an intangible, representative number, you might view the purchase of an index
option as buying a value that changes over time as market sentiment and prices fluctuate.
An investor purchasing an index option obtains certain rights per the terms of the
contract. In general, this includes the right to demand and receive a specified
amount of cash from the writer of a contract with the same terms.
Option Classes
Available strike prices, expiration months and the last trading day can vary with
each index option class, a term for all option contracts of the same type (call
or put) and style (American, European or Capped) that cover the same underlying
index. To determine the contract terms for the option class(es) you wish to employ,
please contact either the exchange where the option is traded or The Options Industry
Council.
Strike Price
The strike price, or exercise price, of a cash-settled option is the basis for determining
the amount of cash, if any, that the option holder is entitled to receive upon exercise.
See Exercise Settlement for further explanation.
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In-the-money, At-the-money, Out-of-the-money
An index call option is in-the-money when its strike price is less than the reported
level of the underlying index. It is at-the-money when its strike price is the same
as the level of that index and out-of-the-money when its strike price is greater
than that level.
An index put option is in-the-money when its strike price is greater than the reported
level of the underlying index. It is at-the-money when its strike price is the same
as the level of that index and out-of-the-money when its strike price is less than
that level.
Premium
Premiums for index options are quoted like those for equity options, in dollars
and decimal amounts. An index option buyer will generally pay a total of the quoted
premium amount multiplied by $100 for the contract. The writer, on the other hand,
will receive and keep this amount.
The amount by which an index option is in-the-money is called its intrinsic value.
Any amount of premium in excess of intrinsic value is called an option's time value.
As with equity options, time value is affected by changes in volatility, time until
expiration, interest rates and dividend amounts paid by the component securities
of the underlying index.
Exercise & Assignment
The exercise settlement value is an index value used to calculate how much money
will change hands, the exercise settlement amount, when a given index option is
exercised, either before or at expiration. The value of every index underlying an
option, including the exercise settlement value, is the value of the index as determined
by the reporting authority designated by the market where the option is traded.
Unless OCC directs otherwise, the value determined by the reporting authority is
conclusively presumed to be accurate and deemed to be final for the purpose of calculating
the exercise settlement amount.
In order to ensure that an index option is exercised on a particular day before
expiration, the holder must notify his brokerage firm before the firm's exercise
cut-off time for accepting exercise instructions on that day. On expiration days,
the cut-off time for exercise may be different from that for an early exercise (before
expiration). Note: Different firms may have different cut-off times for accepting
exercise instructions from customers, and those cut-off times may be different for
different classes of options. In addition, the cut-off times for index options may
be different from those for equity options.
Upon receipt of an exercise notice, OCC will assign it to one or more Clearing Members
with short positions in the same series in accordance with its established procedures.
The Clearing Member will, in turn, assign one or more of its customers, either randomly
or on a first-in first-out basis, who hold short positions in that series. Upon
assignment of the exercise notice, the writer of the index option has the obligation
to pay this amount of cash. Settlement and the resulting transfer of cash generally
occur on the next business day after exercise.
Note: Most firms require their customers to notify the firm of the customer's intention
to exercise at expiration, even if an option is in-the-money. You should ask your
firm to thoroughly explain its exercise procedures, including any deadline your
firm may have for exercise instructions on the last trading day before expiration.
AM & PM Settlement
The exercise settlement values of equity index options are determined by their reporting
authorities in a variety of ways. The two most common are:
PM settlement - Exercise settlement values are based on the reported level of the
index calculated with the last reported prices of the index's component stocks at
the close of market hours on the day of exercise.
AM settlement - Exercise settlement values are based on the reported level of the
index calculated with the opening prices of the index's component stocks on the
day of exercise.
If a particular component security does not open for trading on the day the exercise
settlement value is determined, the last reported price of that security is used.
Investors should be aware that the exercise settlement value of an index option
that is derived from the opening prices of the component securities may not be reported
for several hours following the opening of trading in those securities. A number
of updated index levels may be reported at and after the opening before the exercise
settlement value is reported. There could be a substantial divergence between those
reported index levels and the reported exercise settlement value.
American vs. European Exercise
Although equity option contracts generally have only American-style expirations,
index options can have either American- or European-style.
In the case of an American-style option, the holder of the option has the right
to exercise it on or at any time before its expiration date. Otherwise, the option
will expire worthless and cease to exist as a financial instrument. It follows that
the writer of an American-style option can be assigned at any time, either when
or before the option expires, although early assignment is not always predictable.
A European-style option is one that can only be exercised during a specified period
of time prior to its expiration. This period may vary with different classes of
index options. Likewise, the writer of a European-style option can be assigned only
during this exercise period.
Exercise Settlement
The amount of cash received upon exercise of an index option or when it expires
depends on the closing value of the underlying index in comparison to the strike
price of the index option. The amount of cash changing hands is called the exercise
settlement amount. This amount is calculated as the difference between the strike
price of the option and the level of the underlying index reported as its exercise
settlement value, in other words, the option's intrinsic value, and is generally
multiplied by $100. This calculation applies whether the option is exercised before
or at its expiration.
In the case of a call, if the underlying index value is above the strike price,
the holder may exercise the option and receive the exercise settlement amount. For
example, with the settlement value of the index reported as 79.55, the holder of
a long call contract with a 78 strike price would exercise and receive $155 [(79.55
- 78) x $100 = $155]. The writer of the option would pay the holder this cash amount.
In the case of a put, if the underlying index value is below the strike price, the
holder may exercise the option and receive the exercise settlement amount. For example,
with the settlement value of the index reported as 74.88 the holder of a long put
contract with a 78 strike price would exercise and receive $312 [(78 - 74.88) x
$100 = $312]. The writer of the option would pay the holder this cash amount.
Closing Transactions
As with equity options, an index option writer wishing to close out his position
buys a contract with the same terms in the marketplace. In order to avoid assignment
and its inherent obligations, the option writer must buy this contract before the
close of the market on any given day to avoid notification of assignment on the
next business day. To close out a long position, the purchaser of an index option
can either sell the contract in the marketplace or exercise it if profitable to
do so.