Trading Index Options: Playing the Broader Market

An index option is a special type of option, with the underlying not a single stock but a representation of the broader market. Popular indices on which index options can be traded include the S&P 500, the Dow Jones Industrials, and many others.

The market for index options has been expanding rapidly in recent years, along with the popularity of more traditional options. According to the Chicago Board Options Exchange (CBOE), index option trading first exceeded one million contracts per day in 2008.
By the end of 2008, volume above five million contracts per day was common. Growth in these highly specialized options has been dramatic.

Index options are traded on several U.S. exchanges, including the American (AMEX), CBOE, and Philadelphia (PHLX). Like the better-known stock-based option, all index options are guaranteed and cleared by the Options Clearing Corporation (OCC). Indices include not only well-known stock market indices (S&P 500, Nasdaq, and S&P 500, for example), but also debt securities, foreign currencies, and even economic indicators like the consumer price index (CPI).

An index value is calculated in one of several ways, and the methodology for valuation of the index will affect the movement in value of any related options. In addition, while all stock-based options in the United States can be exercised or closed at any time (American style), some index options cannot and are ruled using the European-style rules (meaning that options can be closed or exercised only on the day of expiration or within a short time frame immediately before expiration). Others adjust the valuation of options by contractually limiting the exercise window, which is a capped-style option. This distinction also matters to anyone considering opening trades in index options. In other words, the terms for index options are not as standardized as those for stock-based options.

Smart Investor Tip

Before opening any index option trades, research the specific terms in effect. Contact the exchange that trades the index option or contact the Options Industry Council (OIC) at 1-888-OPTIONS or on their web site, . The OIC also publishes a useful pamphlet, Understanding Index Options, which can be downloaded free at .

By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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