What it means
The buyer pays a premium up front and that premium is the most they can lose. The seller, or writer, receives the premium and takes on an open-ended obligation to pay if the index moves against them, which is why writing options requires margin.
The payout is calculated in index points and converted into money by a contract multiplier. If a call has a strike of 5,000, the index closes at 5,120 and the multiplier is $100, the holder receives 120 points times $100 in cash.
Index options are used most heavily for portfolio protection. Buying index puts is the closest thing to insurance against a broad market fall, and like insurance the cost is real whether or not the event happens.
They are also used to generate income. An investor holding a diversified portfolio may sell index calls above the current level, collecting premium in exchange for capping their upside if the market rallies hard.
The nuance to appreciate is that an option's value moves for reasons other than direction. Time decay steadily erodes the premium as expiry approaches, and a rise or fall in expected volatility can change the price sharply even when the index barely moves.
Position size deserves particular care with these contracts. A single index option can represent hundreds of thousands of dollars of exposure, so a small number of contracts is often enough to hedge a substantial portfolio.
In practice
Real-world examples.
Example
A family office holding a $20 million equity portfolio buys index puts 10% below the current market level ahead of an election, accepting a premium cost of about 1.5% of the portfolio as the price of protection.
Example
A charity endowment sells index call options 8% above the current index level each quarter, collecting premium income to help fund its grant programme and accepting that a strong rally would cap its gains.
Example
A hedge fund expects a jump in market volatility rather than a particular direction, so it buys both an index call and an index put at the same strike, profiting if the index moves sharply either way. The trade only pays if the move is larger than the combined cost of the two premiums, which is a high bar in a calm market.
Formula
Calculation
Cash settlement on a call = (Index level at expiry - Strike) x Multiplier, floored at zero, and Net profit = Settlement - Premium paid.
Suppose an investor buys one index call with a strike of 5,000 for a premium of 60 index points, with a contract multiplier of $100. Cost of the option = 60 x $100 = $6,000. The breakeven level is the strike plus the premium, or 5,000 + 60 = 5,060.
At expiry the index closes at 5,120. Settlement = (5,120 - 5,000) x $100 = 120 x $100 = $12,000. Net profit = $12,000 - $6,000 = $6,000, a 100% return on the premium from a 2.4% move in the index. Had the index closed at 4,950, the option would have expired worthless and the loss would have been the full $6,000 premium.Case study
Seen in the real world.
Ashcombe Endowment Trust is an invented institution used purely as an illustrative example. Its investment committee held $40 million in equities and was unwilling to sell ahead of a spending commitment nine months away.
Instead it bought index put options covering $25 million of exposure at a strike 12% below the market, at a premium of roughly 1.8%, or about $450,000. The market fell 18% over the following six months, and the puts paid out around $1.5 million, cushioning a portfolio loss of about $7.2 million.
The fictional committee was candid in its minutes that the outcome flattered the decision. In three of the previous four years the same protection would have expired worthless and cost the trust several hundred thousand dollars for nothing.
Watch out
Common mistakes.
- Treating a bought option as a cheap way to take a large position, forgetting that the entire premium is lost if the index does not move far enough in time.
- Selling index options without understanding that the potential loss is far larger than the premium received, especially on uncovered call positions.
- Comparing option prices only by premium rather than by strike, expiry and implied volatility, which is like comparing insurance policies by price alone.
Questions
People also ask.
Are index options settled in shares?
No, they settle in cash against the official index level, which is one of their main practical advantages over single-share options.
What is time decay?
It is the gradual loss of an option's value as expiry approaches, and it accelerates in the final weeks of the contract's life.
Can index options be exercised early?
It depends on the contract, since some index options are European style and can only be exercised at expiry while others are American style and can be exercised earlier.
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