Definition: Index options track the performance of an index such as the Dow Jones Industrial Average or the S&P 500, and offer the option holder the right to buy or sell the underlying index.
What Does Index Options Mean?
What is the definition of index option? Index options are broadly used as hedging strategies to mitigate portfolio risk. Option holders can buy or sell the underlying index at a predetermined price (strike price) on or before maturity, and they are free to decide whether they want to exercise the option or not.
Index options can include a call (buy) or a put (sell) option, and they are quoted on a multiplier of 100. With a careful strategy, investors can offset portfolio losses using index options to hedge the portfolio position. Although it is difficult to accurately estimate a portfolio’s future performance, index options can offer a close estimate of how a particular index could perform during a market downturn, thus mitigating investment risk. Index options are cash-settled.
Let’s look at an example.
Example
Jerry is an option holder in S&P 500, an index that represents many U.S. large caps and can offer some great returns. Jerry is optimistic about the market and believes that the S&P 500 will grow further over the next months. Therefore, he buys a 3-month index call option at a strike price of $1,690.8 for a price of $5.12 per contract, thereby paying a premium of $5.12 x 100 = $512.
Three months later, the S&P 500 rises to $1,712.5, so Jerry’s option expires in-the-money (strike price < market price). Jerry decides to exercise his option for a settlement value of $1,712.5, thus realizing a gross profit of $1,712.5 – $1,690.8= $21.7 x 100 = $2,170 minus the premium of $512, his net profit is $1,658.
If the S&P 500 had dropped to $1,675.48, Jerry’s option would expire out-of-the-money (strike price > market price). Jerry would not exercise his option for a settlement value of $1,675.48, and his option would expire worthless, leaving him with a net loss of $512, the premium he paid for the index option.
Summary Definition
Define Index Options: An index option means a derivative right that gives the owner the ability to purchase or sell the security for the value of the underlying index.
