What are index options and how do they work?

An index option is a financial derivative that gives the right, but not the obligation, to buy or sell the value of an underlying index. Index options always have a strike price, an expiration date and an underlying index that the options follow. All index options are cash-settled.

Strike price

Also known as the exercise price, the strike price of an index option is the price that is taken to compare the settlement price with, in order to calculate the cash settlement, the investor will receive.

Expiration date

Derivatives such as index options have an expiration date. This is the last day that the option contract is trading on the exchange. The holder can choose to close the position or to let the contract expire. As index options are cash-settled, the investor receives or pays cash, depending on whether the option still has value when it expires. At expiry, the issuing exchange determines whether there is a remaining value. If there is any, this is paid out to the investor.

Underlying index

In finance, derivatives have an underlying value. This can be an index, (basket of) assets, or even another derivative. It goes without saying that the underlying of an index option is an index.

Costs of an index option

The price of an option is affected by several variables. These are the current stock price, the intrinsic value, implied volatility, interest rates, cash dividends paid, the type of option, and the time to expiration or the time value. The closer the option comes to maturity, the lower the time value will be.

When you buy an option, you open a long position. For this position, you pay a premium. The number of units of the underlying that is covered by a single option contract is usually set by a multiplier. Depending on the option series, there can be daily, weekly, monthly and quarterly options. The contract size is the value by which the underlying is multiplied in order to determine the premium.

On top of the premium, it is also possible that you have to pay broker fees. These depend on the broker and can usually be found in the fee schedule or on the website of the broker. Usually, the broker also charges transactions costs for index options, which can also be found in the fee schedule of the broker.

How does the settlement work?

As mentioned earlier, index options are cash-settled since the underlying (the index) cannot be physically delivered. Investors that have long positions in an index call option that still have value on the expiry date, will automatically receive a cash settlement. Investors that have short positions in an index call option that still has value on the expiry date, have to then pay this cash amount.

When the index option does not have any value at expiry, it is automatically booked out of your portfolio against a value of zero. In this case, there will not be a cash settlement.

What is the target group for index options?

Index options are typically used by investors who can bear the loss of capital and have sufficient knowledge of (similar) financial instruments. Generally, investors that invest in the products have a relatively short investment horizon (shorter than five years). Some index options are considered riskier than others. You can find the risk indicator of a specific product in the Key Investor Document (KID). All index options should have a KID. This is a 3-page document which describes the characteristics of the products and risks associated with the product. Apart from the KID, information about contract specifications and the underlying can usually be found on the exchange website. The symbol of an option refers to the underlying of the option.

Risk and reward

Investing can be rewarding but it is not without risk. Like all other financial products, also investing in index options comes with the risks of losses. With a long position in a put or call option, the maximum loss is the premium you paid. If you have a short position in an option, the maximum profit is the premium you received when selling (writing) the option. Whether it is a call or a put option. The maximum loss, on the other hand, does differ. A short position in a call option has unlimited potential loss. For a short position in a put option, the maximum loss is the exercise price minus the received premium.

At ESKIMO we are open and transparent about the risks that come with investing. Before you start to invest, there are a number of factors to consider. It helps to think about how much risk you are willing to take and which products match your knowledge. Additionally, it is not advisable to invest using money that you may need in the short term or to enter into positions which could cause financial difficulties. It all starts with thinking about what kind of investor you want to be.

The information in this article is not written for advisory purposes, nor does it intend to recommend any investments. Investing involves risks. You can lose (a part of) your deposit. We advise you to only invest in financial products which match your knowledge and experience.