An index option is a derivative financial product. With an index option, investors have the right to purchase or sell an underlying index’s value at a stated price either on or before the expiration date. During the process, no exact stocks are purchased or sold, and index options are generally settled via cash.
Investors often use index call and index put options as investment tools. Speculators and traders attempt to gain profits on the general direction of an underlying index. At the same time, they put very little money at risk.
For long index call options, the limitless profit potential is appealing. Besides, the risk is limited to the premium amount which is paid for the index option no matter what the index level is at expiration.
In terms of long index put options, similarly, the risk is also limited to the premium amount, and the possible profit is capped at the index level.
In addition, index options can also be used for improving portfolio diversification, especially when the investor does not intend to make direct investments in the underlying stocks of the index.
Index options can also help investors hedge particular risks in a portfolio in various ways. While the American-style index options could be exercised ahead of the expiration date whenever you want, the Europe-style index options, on the other hand, are only able to be exercised on the expiration date.
To help you understand the index option better, here is an example. Suppose there is an index A having a level of 500, and you want to buy a call option on index A with a strike price of 505. Through the index option, the contract can have a multiplier (usually 100) which decides the overall price. If the call option is priced at $10, then the whole contract will cost you $10×100, which is $1,000 in all.
You have to notice that the underlying asset is the cash level of the index adjusted by the multiplier. In the example above, the figure is $100×500, which is $50,000. This means you can purchase the option at $1,000 and use the left $4,900 in other places.