Stock market index options are financial derivative contracts whose value is derived from underlying stock market indexes. This option gives the holder the right (but not the obligation) to buy or sell the underlying index at a specified price. You can buy and sell index options, which are called call options and put options. Check out this article for more information on index options.
Understanding Index Options
An index call is a specific type of options contract used in derivatives trading. These contracts involve an underlying asset that isn’t a stock but an index, such as the Nifty 50 in the Indian stock market. This index comprises the 50 most significant and highly traded stocks listed on the National Stock Exchange (NSE) of India. The purpose of an index call is to give the holder the right to purchase a certain number of units of the underlying index at a predetermined price, known as the strike price, on the option contract’s expiration date.
The idea behind holding an index call is that the holder hopes the index’s price will rise above the strike price before the option expires. This way, they can exercise their right to buy the index at the lower strike price and then sell it at the higher market price, making a profit.
On the flip side, the seller of the index call, often referred to as the “writer,” is obliged to sell the underlying index to the holder if the holder decides to exercise the option. The writer’s goal is that the index’s price remains below the strike price, so they won’t have to sell the index for less than its actual value.
Index options are traded on exchanges and are commonly used for portfolio hedging, speculating on market trends, and risk management. Unlike individual stock options, the value of an index option is based on the overall performance of the underlying index rather than the performance of any individual stock or security.
How Index Options Work?
Unlike stock options, index options trading does not involve actual stocks since the underlying index is used. Index futures contracts are often used as the underlying asset for index options. Since physical delivery of the underlying index is not possible, settlements are made through cash payments. Typically, index options are European-style options that expire only at the end of the term. In this case, there is no early exercise. Index call options allow for the purchase of the index, and index put options allow for its sale.
Index option derivatives are low-risk instruments used to take advantage of the direction of an index. In an index call option, the profit potential is unlimited, while the downside loss is limited to the premium paid. Put options on indexes have a profit potential limited to the index level less the premium paid, whereas put options have a downside limited to the premium paid.
Most indices and exchanges have a multiplier of 100 that determines the overall contract price. Investing in index options offers the advantage of incurring limited losses while getting exposure to a basket of stocks at a fraction of the price.
The investor’s portfolio is best protected by locking in any gains accumulated if the market declines beyond a predetermined floor price. It can be achieved by buying put options on all of the index holdings in order to lock in a specific sale price. This strategy is suitable for small portfolios and protects them from market crashes. Nevertheless, if the portfolio is large and diversified, insuring each position in this manner is not cost-effective.
Types of Options
In India, well-known indices include Sensex, Nifty, Bank Nifty, and Nifty Financial Services. However, index options are primarily available for two of these indices: the Nifty 50 and Nifty Bank. Traders can use index options to take positions on these indices instead of individual stocks.
By employing opposing index options for hedging, traders can safeguard their portfolios from market volatility. It’s important to note that index options are typically introduced once futures contracts for the same index are already available. After establishing lot sizes, strike prices, and expiration dates for index options, they become tradable financial instruments. Traders can use index options through a demat account app.
Index call options allow the buyer to profit from the underlying index’s gains if its price rises above a predetermined strike price. Depending on how quickly the index rises, this type of option offers unlimited profit potential. However, index options cannot be profitable unless the underlying asset’s value increases, which is why they are speculative instruments. If you are unfamiliar with index options and futures, Share India can guide you.