Index Options - Part 3

Equity vs. Index Options

An equity index option is an option whose underlying investment instrument is intangible—an equity index. The market value of an index put and call tends to rise and fall in relation to the underlying index. The price of an index call will generally increase as the level of its underlying index increases, and its purchaser has unlimited profit potential tied to the strength of these increases. The price of an index put will generally increase as the level of its underlying index decreases, and its purchaser has substantial profit potential tied to the strength of these decreases.

Pricing Factors

Generally, the factors that affect the price of an index option are the same as those affecting the price of an equity option: value of the underlying instrument (an index in this case), strike price, volatility, time until expiration, interest rates, and dividends paid by the component securities.

Underlying Instrument

The underlying instrument of an equity option is a number of shares of a specific stock, usually 100 shares. Cash-settled index options do not relate to a particular number of shares. Rather, the underlying instrument of an index option is usually the value of the underlying index of stocks times a multiplier, which is generally U.S. $100.

Volatility

Indexes, by their nature, are less volatile than their individual component stocks. The up and down movements of component stock prices tend to cancel one another out, lessening the volatility of the index as a whole. However, the volatility of an index can be influenced by factors more general than can affect individual equities. These can range from investors' expectations of changes in inflation, unemployment, interest rates or other economic indicators issued by the government and political for military situations.

Risk

As with an equity option, an index option buyer's risk is limited to the amount of the premium paid for the option. The premium received and kept by the index option writer is the maximum profit a writer can realize from the sale of the option. However, the loss potential from writing an uncovered index option is generally unlimited. Any investor considering writing index options should recognize that there are significant risks involved.

Cash Settlement

The differences between equity and index options occur primarily in the underlying instrument and the method of settlement. Generally, when an index option is exercised by its holder, and when an index option writer is assigned, cash changes hands. Only a representative amount of cash changes hands from the investor who is assigned on a written contract to the investor who exercises his purchased contract. This is known as cash settlement.

Purchasing Rights

Purchasing an index option does not give the investor the right to purchase or sell all of the stocks that are contained in the underlying index. Because an index is simply an intangible, representative number, you might view the purchase of an index option as buying a value that changes over time as market sentiment and prices fluctuate. An investor purchasing an index option obtains certain rights per the terms of the contract. In general, this includes the right to demand and receive a specified amount of cash from the writer of a contract with the same terms.

Option Classes

Available strike prices, expiration months and the last trading day can vary with each index. Option class is a term for all option contracts of the same type (call or put) and style (American, European or capped) that cover the same underlying index. To determine the contract terms for the option class(es) you wish to employ, please contact either the exchange where the option is traded or the Options Industry Council(OIC).

Strike Price

The strike price, or exercise price, of a cash-settled option is the basis for determining the amount of cash, if any, that the option holder is entitled to receive upon exercise. See Exercise Settlement(below) for further explanation.

In-the-money, At-the-money, Out-of-the-money

An index call option is in-the-money when its strike price is less than the reported level of the underlying index. It is at-the-money when its strike price is the same as the level of that index and out-of-the-money when its strike price is greater than that level.

An index put option is in-the-money when its strike price is greater than the reported level of the underlying index. It is at-the-money when its strike price is the same as the level of that index and out-of-the-money when its strike price is less than that level.

Premium

Premiums for index options are quoted like those for equity options, in dollars and decimal amounts. An index option buyer will generally pay a total of the quoted premium amount multiplied by $100 for the contract. The writer, on the other hand, will receive and keep this amount.

The amount by which an index option is in-the-money is called its intrinsic value. Any amount of premium in excess of intrinsic value is called an option's time value. As with equity options, time value is affected by changes in volatility, time until expiration, interest rates and dividend amounts paid by the component securities of the underlying index.

Exercise & Assignment

The exercise settlement value is an index value used to calculate how much money will change hands, the exercise settlement amount, and when a given index option is exercised, either before or at expiration. The value of every index underlying an option, including the exercise settlement value, is the value of the index as determined by the reporting authority designated by the market where the option is traded. Unless the Office of the Comptroller of the Currency (OCC) directs otherwise, the value determined by the reporting authority is conclusively presumed to be accurate and deemed to be final for the purpose of calculating the exercise settlement amount.

In order to ensure that an index option is exercised on a particular day before expiration, the holder must notify his brokerage firm before the firm's exercise cut-off time for accepting exercise instructions on that day. On expiration days, the cut-off time for exercise may be different from that for an early exercise (before the index option expiration). Note: different firms may have different cut-off times for accepting exercise instructions from customers, and those cut-off times may be different for different classes of options. In addition, the cut-off times for index options may be different from those for equity options.

Upon receipt of an exercise notice, OCC will assign it to one or more clearing members with short positions in the same series in accordance with its established procedures. The clearing member will, in turn, assign one or more of its customers, either randomly or on a first-in first-out basis, who hold short positions in that series. Upon assignment of the exercise notice, the writer of the index option has the obligation to pay this amount of cash. Settlement and the resulting transfer of cash generally occur on the next business day after exercise.

Note: most firms require their customers to notify the firm of the customer's intention to exercise at expiration, even if an option is in-the-money. You should ask your firm to thoroughly explain its exercise procedures, including any deadline your firm may have for exercise instructions on the last trading day before expiration.

AM & PM Settlement

The exercise settlement values of equity index options are determined by their reporting authorities in a variety of ways. The two most common are:

PM settlement: Exercise settlement values are based on the reported level of the index calculated with the last reported prices of the index's component stocks at the close of market hours on the day of exercise.

AM settlement: Exercise settlement values are based on the reported level of the index calculated with the opening prices of the index's component stocks on the day of exercise.

If a particular component security does not open for trading on the day the exercise settlement value is determined, the last reported price of that security is used.

Investors should be aware that the exercise settlement value of an index option that is derived from the opening prices of the component securities may not be reported for several hours following the opening of trading in those securities. A number of updated index levels may be reported at and after the opening before the exercise settlement value is reported. There could be a substantial divergence between those reported index levels and the reported exercise settlement value.

American vs. European Exercise

Although equity option contracts generally have only American-style expirations, index options can have either American- or European-style expirations.

In the case of an American-style option, the holder of the option has the right to exercise it on or at any time before its expiration date. Otherwise, the option will expire worthless and cease to exist as a financial instrument. It follows that the writer of an American-style option can be assigned at any time, either when or before the option expires, although early assignment is not always predictable.

A European-style option is one that can only be exercised during a specified period of time prior to its expiration. This period may vary with different classes of index options. Likewise, the writer of a European-style option can be assigned only during this exercise period.

Exercise Settlement

The amount of cash received upon exercise of an index option or when it expires depends on the closing value of the underlying index in comparison to the strike price of the index option. The amount of cash changing hands is called the exercise settlement amount. This amount is calculated as the difference between the strike price of the option and the level of the underlying index reported as its exercise settlement value—in other words, the option's intrinsic value—and is generally multiplied by $100. This calculation applies whether the option is exercised before or at its expiration.

In the case of a call, if the underlying index value is above the strike price, the holder may exercise the option and receive the exercise settlement amount. For example, with the settlement value of the index reported as 79.55, the holder of a long call contract with a 78 strike price would exercise and receive $155 [(79.55 - 78) x $100 = $155]. The writer of the option would pay the holder this cash amount.

In the case of a put, if the underlying index value is below the strike price, the holder may exercise the option and receive the exercise settlement amount. For example, with the settlement value of the index reported as 74.88 the holder of a long put contract with a 78 strike price would exercise and receive $312 [(78 - 74.88) x $100 = $312]. The writer of the option would pay the holder this cash amount.

Closing Transactions

As with equity options, an index option writer wishing to close out his position buys a contract with the same terms in the marketplace. In order to avoid assignment and its inherent obligations, the option writer must buy this contract before the close of the market on any given day to avoid notification of assignment on the next business day. To close out a long position, the purchaser of an index option can either sell the contract in the marketplace or exercise it if profitable to do so.

Read more about index options strategies in Part 4 of this guide. To get started with online equity trades, open your account at Firstrade today!

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