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?
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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.
