Index Options
Introduced in 1981, index options are options whose underlying is not a single stock but an index comprising many stocks. Index calls and puts allow investors to gain exposure to the entire market or specific segments of the market with a single trading decision and often thru one transaction. Obtaining the same level of diversification using individual stocks or individual stock options require numerous transactions and consequently slower decision making and higher costs.
Leverage & Predetermined Risk for the Buyer
Like equity options, index options offer the buyer leverage and predetermined risk. Index options offers leverage to the index option buyer as the premium paid relative to the contract value is small. Consequently, for a small percentage moves of the underlying index, the index option holder can see large percentage gains for his position. Furthermore, risk is predetermined as the most the index option buyer can lose is the premium paid to hold the options.
Contract Multiplier
Index options typically have a contract multiplier of $100. The contract multiplier is used to compute the cash value of each index option contract.
Premium
Similar to equity options, index options premiums are quoted in dollars and cents. The price of a single index option contract can be determined by multiplying the quoted premium amount by the contract multiplier. This is the amount that an index option buyer will need to pay to purchase the option and the amount that the index option writer will receive when selling the option.
Rights Conferred
As index options are cash-settled options, the holder of an index option does not possess the right to purchase or sell the underlying stocks of the index but rather, he or she is entitled to demand the equivalent cash value from the option writer upon exercising his option.
