by Amanda Harvey
Index options trading functions in basically the same manner as trading regular options, with the main difference being that the underlying security is an entire index, rather than a single stock. Trading index options allows a trader to participate in the movement of an entire cross section of stocks in an easy and relatively low-cost way.
As with regular options trading, index options trading involves the purchase of a contract with the paying of a premium. This contract entitles the holder to exercise their option within its duration. Index options are cash-settled options, and this means that exercising the option results in the payment of cash, rather than the purchase of any security.
What is an Index?
An index is a measure of the average price movement of a group of stocks. These may be top performing companies as measured by indexes such as the Dow Jones Industrial Average (DJIA) or the Standard & Poor's 500, or smaller companies (small cap) which are represented by indexes like the Russell 2000 or the S&P 600.
Which Indexes Offer Options?
The Chicago Board Options Exchange (CBOE) was established in 1973 and was the first exchange to list standardized, exchange-traded stock options. In 1983, the CBOE led the way in offering cash-settled index options. Available through the CBOE are options on the S&P 500, the S&P 100, the DJIA, the Russell 2000 and the Nasdaq-100. In April 2015, the CBOE began to offer options on the MSCI Emerging Markets Index (MXEF).
Making Index Options Trading Decisions
When selecting an index to trade, determining the expected direction of the price, and deciding on an entry and exit strategy, most of the same factors apply as with trading other types of options.
Many forms of technical analysis, as well as various indicators, can provide insight into the probable price movements that will be experienced by an index. Measuring volatility is one key component of assessing index conditions. Current and historical price data are also important to any analysis of index performance.
Some popular techniques for predicting the likely turning point of a trend in index prices include the Fibonacci retracement level, Elliott waves and Pivot Points. Chart patterns can also be effectively applied to analyzing index prices.
The CBOE website offers lots of information regarding index options trading strategies; both in general, and also specifically in regard to particular indexes. These strategies range from simple call and put options, to more complex straddles, spreads and collars.
Benefits of Index Options Trading
One of the greatest benefits of trading index options is that these options offer inbuilt diversification. The outcome is not dependent on the performance of only one stock, but on the average of the whole range of stocks. This tends to produce a lower level of risk than investing in a single stock.
The averaging result of an index also levels out the volatility to a certain degree when compared with the individual stocks. This provides a somewhat more predictable trading arena.
Good liquidity is another advantage of index options trading. There is plenty of demand for these options, which creates sufficient volume to ensure that it is generally easy to obtain reasonable prices.
Another benefit of trading index options for U.S. based traders is a tax advantage which may be attained by the fact that a percentage of capital gains from cash settlement are taxed long-term rather than short-term.
Drawbacks of Index Options Trading
One drawback to trading index options is that the reduced risk and volatility can also mean less chance of the highs that offset the lows experienced by trading individual stocks. It could be fair to compare trading index options to riding the merry-go-round, while trading stock options can be like the rollercoaster. Whether or not missing out on the highs of the rollercoaster is a drawback or not depends on a trader’s tolerance for a high risk/reward ratio.
Depending on the investment approach of a trader, the fact that there is no actual underlying asset to be purchased, but rather a cash settlement, may be seen as a disadvantage. However, there are many traders who prefer cash to securities, or who are simply trading options to benefit from selling the contracts at an increased price, and do not intend to exercise the contracts. Once again, this possible drawback is subjective.
Index options trading offers an effective method of profiting from the average movement in price of a range of stocks. There is generally less risk and volatility in trading these options, as the averaging process offers a typically smoother trading scenario. While there may not be returns as high as those that are sometimes experienced trading stock options, there are usually not the same lows either. For traders looking to trade highly liquid, cash-settled options, index options present a great choice.