5 Things You Must Know to Trade Index Options

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Stock options give the option holder the right, but not the obligation, to buy or sell particular stocks for a particular price, called the strike price, within a specified time.

Options equity index options trading example called contingent claims are derivatives, so called because their value derives from other securities called the underlying securityor just underlying or underlierwhich in the case of stock options are particular stocks. They are used extensively for hedging because options allow an investor to protect a position for a small cost, and speculators like them because their profit potential is much greater than the underlying securities.

Equity index options trading example common stock, there are also options for stock indexes, foreign exchange, agricultural commodities, precious metals, and interest rate futures. Although options were originally traded in the over-the-counter OTC market, where the contract terms were negotiated, option trading really took off when the first option exchange, the Chicago Board Options Exchange CBOEwas organized in to trade standardized contracts, increasing the market and liquidity of options.

Options trading began on April 26,with 1. Since then, trading volumes have increased substantially, with billions of contracts traded in Leverage is the fundamental advantage of options. A small investment can benefit from the price movements of securities that would either cost much more to own outright, or would require a much greater risk.

It is because of leverage that options are equity index options trading example financial instruments for hedging a long or short position, or for pure speculation. Equity index options trading example course, options have a downside; otherwise, why would anyone bother buying the underlying security. Although the risk is limited to the premium for equity index options trading example option holder, the disadvantage of buying options is that they can expire completely worthless, and often will.

If the stock price does not move sufficiently in the right direction before the expiration date, then the investor loses the entire investment. I review my articles periodically to make sure that they are up-to-date. Some of the examples are dated, but if the examples continue to illustrate the basic principles, which they usually do, then I continue to use those examples, since it takes a lot of work to redo, while redoing them using more recent equity index options trading example offers no pedagogical advantage.

It would be virtually impossible to even approach getting the same return on investment buying the stock itself! So even if the option was closed out at the market top, profits would have been minimal after subtracting the call premium and transaction costs. The elements of a standardized option contract specifies whether it is a put or call, its style as to when the option can be exercised, the underlying security, the strike price, the expiration date, and the number of shares of the underlying security for each contract, which is almost always shares for equity options.

However, different countries may have different equity index options trading example. Calls and puts are the 2 types of options.

A call gives the holder the right, but not the obligation, to buy a specific security equity index options trading example a set price, called the strike or exercise price. A put gives the holder the right, but equity index options trading example the obligation, to sell a particular security for the strike price.

If the price of the underlying security moves substantially before expiration dates, then new options are created with strike prices closer to the new market price of the underlying security. The older contracts are then exercised, closed out, or left to expire.

There equity index options trading example 3 styles of options that differ as to when the option can be exercised. American-style equity index options trading example allow the holder to exercise the option at any time before expiration, whereas European-style options allow the holder to exercise only for a short time before the expiration date.

The option style is not related to geography — most options equity index options trading example in Europe are American-style options. All equity options are American-style options, but most foreign currency options and CBOE stock index options are European-style options.

Note that, although European-style options can only be exercised during a brief time right before expiration, the options can be sold before then.

Most options that require a equity index options trading example settlement instead of the delivery of securities are European-style options, because it makes no sense to exercise an option for cash when it can simply be sold for cash. The capped-style option can only be exercised for a specific time before expiration, unless the underlying security reaches the cap price, in which case, the capped-style option is exercised automatically. This cap limits the profit potential of the option for the holder and the risk for the option writer.

A standardized option contract is always for shares of the underlying security, unless it is adjusted for a stock split, or some other event that would affect the relationship of the equity index options trading example to the underlying security. Options always expire on the Saturday following the 3 rd Friday of the expiration month, although they must be exercised by the Friday before expiration since that is the last trading day.

The Saturday following expiration is used so that brokers can confirm customer option positions and related paperwork incurred by expiration and exercise. There are at least 2 near-term options which expire in the nearest 2 months, and there are 2 long-term options. When the current month's options expire, then more are created that expire in the month after the next.

The expiration dates of long-term options are based on specific sequences. The exact months of expiration are based on 3 different sequential cycles: For larger companies and major indexes for which there is a significant market demand, there are also LEAPS L ong-Term E quity A ntici P ation S ecuritieswhich are special options that initially have expiration dates several years into the future, and equity index options trading example expire in January.

Microsoft is on the January cycle, so before the 3 rd Saturday in November, equity index options trading example, the 2 near-term options are for November and December, the 2 far-term options are for January and April, and the 2 LEAPS expire in January and On the Monday following option expiration in November, the 2 near-term options will be for December and January and the 2 far-term options will be for April and July.

Some option contracts differ slightly from most others. An option class consists of all contracts that have the same type call or putstyle American or Europeanand underlying security. Thus, all Microsoft calls compose an option class, while all Microsoft puts compose another. An option series is composed of the set of all options of the same option class that also have the same strike price and expiration date.

When an investor buys an option contract, that contract is based on what is known about the contract terms equity index options trading example the time; however, events can occur that would change the basic relationship between the option contract and the right that it confers.

For instance, if the company declares a 2-for-1 stock split, equity index options trading example each share of stock will be doubled, but the stock price will be half of what it was prior to the split. Now, consider 2 option holders. Now consider the writers of these 2 options. To prevent these scenarios, adjustments are made to the option contracts sometimes called adjusted optionswhen the relationship to the underlying security is significantly altered.

These alterations can include stock splits, reverse stock splits, stock equity index options trading example or distributions, rights offeringsa reorganization or recapitalization of the company, or a reclassification of the underlying security. It can also occur if the issuer of the underlying security is acquired or merges, or is dissolved or liquidated. There are standard ways to adjusting the contracts in common events, such as stock splits, but, when the event is peculiar, and creates an uncertainty as to how the adjustment should be made, an adjustment panel will decide on the contract adjustments.

All contract adjustments are published by the Options Equity index options trading example Corporation. The adjustments are listed in reverse chronological order, but the page includes a search box for looking equity index options trading example particular options. The effective date is the ex-date established by the primary market in the underlying security. Generally, option contracts are adjusted to maintain the same basic equity index options trading example between the option and the underlying security.

The necessary adjustments in most of these cases can be found by the following equation:. Note that the share number and price are inversely related. If the number of shares is adjusted upward, then the price of each share must be adjusted downward, and vice versa. In a 2-for-1 stock split, contracts are usually adjusted by doubling the number of option contracts, and halving their price. Using the equation above to verify: In cases where the divisor is greater than 1, then each contract is adjusted by altering the number of shares for each contract and their price, to accommodate anyone holding just 1 contract.

Other kinds of adjustments are more rare, and all of these can be found at the Options Clearing Corporation. The search engine provided allows searches for year, month, keywords, or memo number. Options were originally traded over the counter OTCand still are.

The advantages of the OTC market over the exchanges is that the option contracts can be tailored: However, OTC options have greater transaction costs and less liquidity. Organized exchanges offer standardized contracts that are cheaper and easier to sell.

Most options sold in Europe are traded through electronic exchanges. Other exchanges for options in the United States include: Options are traded just like stocks; however, the option holder, unlike the holder of the underlying stock, has no voting rights in the corporation, and is not entitled to dividends.

Brokerage commissions must also be paid to buy, sell, or exercise options, and generally these commissions are a little higher than for stocks. Prices are usually quoted as a minimum amount plus per contract, but phone orders cost more, and broker-assisted trades are the most expensive. Many brokerages also offer a sliding commission scale for active traders, yielding lower commissions for certain minimum number of trades.

The price of the option is known as the premium. When the option is first sold, the option buyer pays the premium to the option writer. Thereafter, it trades in the secondary market. Option premiums can be divided into 2 components: Equity index options trading example options have time value sometimes called extrinsic value because an option, as long as it exists, gives the holder the right to buy or sell the underlying security for the strike price.

The greater the time until equity index options trading example, the greater the chance that the option can become profitable, and thus, the greater the time value. As the remaining time for the option declines, so does its time value, until at expiration it becomes completely worthless, and ceases to exist. Standardized option contracts expire the 3 rd Saturday of the month of expiration; however, the last trading day is the Friday before expiration.

If the security is currently trading above the exercise price of a call, or if the security is currently trading below the strike price of a put, then the option also has intrinsic valuewhich, in the case of equity index options trading example call, is the difference between the current price of the security and the strike price.

If this difference is zero or negative, then the call has no intrinsic value, but only time value. The intrinsic value of a put is the difference between the strike price of the put and the current price of the security.

When an option has intrinsic value, it is said to be in the moneyif the strike price of the option and the price of the underlying security are equal, then the option is said to be at the moneyand if the intrinsic value is negative, then the option is said to be out of the money. A call is created when an investor accepts the legal obligation for a specified time to sell a particular security for a particular strike price. The call writer is said to have a short position.

If the call writer already owns the security on which the call is written, then the call is a covered call ; otherwise, it is a uncovered call or a naked callin which case, if the option is exercised, the call writer will have to buy the stock on the open market for whatever the current price is, which is the risk that a naked call writer bears.

A call writer has the duty to deliver the security for the strike price when the call is exercised. Sometimes, an option seller is considered an option writer—and in many contexts, these 2 words are used as synonyms—but this is not necessarily so, or even likely. Anyone who already owns an option has a long position in it and would most likely close his position by selling it rather than exercising it, because options always have some time value before expiration, so selling an option is usually more profitable than exercising it.

But the option holder has no legal obligation, since he only bought the contract, not write it. However, an option writer sells an option that she created by agreeing to the legal obligation imposed by the contract that she sold for the premium.

She is said to have a short position because, to close out her obligation before expiration, she would have to equity index options trading example back a contract with the same terms that she wrote.

To have a short position in options is similar to having a short position in stocks, except that the option writer creates the option to sell, whereas the short seller of stock must first borrow the stock to sell it, which must eventually be bought back to close out the position. The option writer must also buy back the contract to close out her position before expiration, which she would do if she thought that the option will move more into the money before expiration, but she could also just let the option expire if she thought that the option will not be in the money at expiration, thereby saving the commission of buying the option back, or she could fulfill her obligation when assigned an exercise, because, at expiration, there is no time value left to the option, so it might be cheaper than buying back the option earlier.

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Like stock options, index option prices rise or fall based on several factors, like the value of the underlying security, strike price, volatility, time until expiration, interest rates and dividends.

Narrow-based indexes are based on specific sectors like semiconductors or the financial industry, and tend to be composed of relatively few stocks. Broad-based indexes have many different industries represented by their component companies. As you would expect, however, other broad-based indexes are indeed made up of many different stocks. When stock options are exercised, the underlying stock is required to change hands.

But index options are settle in cash instead. That would be ridiculous. The index value is just a gauge to determine how much the option is worth at any given time. As of this writing, all stock options have American-style exercise, meaning they can be exercised at any point before expiration. Most index options, on the other hand, have European-style exercise.

As with any other option, you can buy or sell to close your position at any time throughout the life of the contract. The last day to trade stock options is the third Friday of the month, and settlement is determined on Saturday. The last day to trade index options is usually the Thursday before the third Friday of the month, followed by determination of the settlement value on Friday.

The settlement value is then compared to the strike price of the option to see how much, if any, cash will change hands between the option buyer and seller.

Stock options and narrow-based index options stop trading at 4: If a piece of news came out immediately after the stock market close, it might have a significant impact on the value of stock options and narrow-based index options. However, since there are so many different sectors in broad-based indexes, this is not so much of a concern.

All of these are very general characteristics of indexes. In practice, there are lots of small exceptions to these general rules. Although the OEX is an index, options traded on it have American-style exercise. This table highlights a few of the general differences between index options and stock options. But make sure you do your homework before trading any index option so you know the type of settlement and the settlement date.

As you read through the plays, you probably noticed that I mentioned indexes are popular for neutral-based trades like condors. Options involve risk and are not suitable for all investors. For more information, please review the Characteristics and Risks of Standardized Options brochure before you begin trading options.

Options investors may lose the entire amount of their investment in a relatively short period of time. Multiple leg options strategies involve additional risks , and may result in complex tax treatments. Please consult a tax professional prior to implementing these strategies.

Implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or the probability of reaching a specific price point. The Greeks represent the consensus of the marketplace as to how the option will react to changes in certain variables associated with the pricing of an option contract.

There is no guarantee that the forecasts of implied volatility or the Greeks will be correct. Ally Invest provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice. System response and access times may vary due to market conditions, system performance, and other factors. Content, research, tools, and stock or option symbols are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy.

The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, are not guaranteed for accuracy or completeness, do not reflect actual investment results and are not guarantees of future results. All investments involve risk, losses may exceed the principal invested, and the past performance of a security, industry, sector, market, or financial product does not guarantee future results or returns. The Options Playbook Featuring 40 options strategies for bulls, bears, rookies, all-stars and everyone in between.

What is an Index Option? Multiple underlying stocks vs. Settlement Method When stock options are exercised, the underlying stock is required to change hands. Settlement Style As of this writing, all stock options have American-style exercise, meaning they can be exercised at any point before expiration.

Settlement Date The last day to trade stock options is the third Friday of the month, and settlement is determined on Saturday. Trading Hours Stock options and narrow-based index options stop trading at 4: Now for the disclaimer All of these are very general characteristics of indexes. Options Guy's Tips As you read through the plays, you probably noticed that I mentioned indexes are popular for neutral-based trades like condors.

Meet the Greeks What is an Index Option?