What Are Index Options & An Equity Index? (2024)

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Introduction

An equity index option is a security which is intangible and whose underlying instrument is composed of equities: 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 generally increases as the level of its underlying index increases. Its purchaser has unlimited profit potential tied to the strength of these increases.
• The price of an index put generally increases as the level of its underlying index decreases. 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 that affect the price of an equity option:

• Value of the underlying instrument (an index in this case)
• Strike price
• Volatility
• Time until expiration
• Interest rates
• 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 correspond 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 $100.

Volatility

Indexes, by nature, are less volatile than their individual component stocks. The up and down movements of component stock prices tend to cancel one another out. This lessens the volatility of the index as a whole. However, factors more general than those affecting individual equities can influence the volatility of an index. These can range from investors' expectations of changes in inflation, unemployment, interest rates or other fundamental data.

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 (seller) 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, cash changes hands when an option holder exercises an index option and when an index option writer is assigned. 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 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

An option class is a term used for option contracts of the same type (call or put) and style (American or European) that cover the same underlying index. Available strike prices, expiration months and the last trading day can vary with each index option class.

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.

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.
• At-the-money when its strike price is the same as the level of that index.
• Out-of-the-money when its strike price is greater than the level of that index.

An index put option is:

• In-the-money when its strike price is greater than the reported level of the underlying index.
• At-the-money when its strike price is the same as the level of that index.
• Out-of-the-money when its strike price is less than the level of that index.

Premium

Premiums for index options are quoted like those for equity options, in dollars and decimal amounts. An index option buyer generally pays a total of the quoted premium amount multiplied by $100 per contract. The writer, on the other hand, receives and keeps 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, changes in volatility, time until expiration, interest rates and dividend amounts paid by the component securities of the underlying index affect time value.

Exercise & Assignment

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

AM & PM Settlement

Reporting authorities determine the exercise settlement values of equity index options in a variety of ways. The two most common are:

• PM settlement - Exercise settlement values 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 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.

When the exercise settlement value of an index option is derived from the opening prices of the component securities, investors should be aware that value might 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 exercise, index options can have either American- or European-style.

In the case of an American-style option, the holder of the option has the right to exercise it on or any business day before its expiration date. The writer of an American-style option can be assigned at any time, either when or before the option expires. Early assignment is not always predictable.

An investor can only exercise a European-style option during a specified period prior to expiration. This period varies 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 at expiration 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 pays 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 pays 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 potential 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.

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Options involve risk and are not suitable for all investors. Certain requirements must be met to trade options. Before engaging in the purchase or sale of options, investors should understand the nature of and extent of their rights and obligations and be aware of the risks involved in investing with options. Please read the options disclosure document titled "Characteristics and Risks of Standardized Options (PDF)" before considering any option transaction. You may also call the Investment Center at 877.653.4732 for a copy. A separate client agreement is needed. Multi-leg option orders are charged one base commission per order, plus a per-contract charge.

The maximum loss, gain and breakeven of any options strategy only remains as defined so long as the strategy contains all original positions. Trading, rolling, assignment, or exercise of any portion of the strategy will result in a new maximum loss, gain and breakeven calculation, which will be materially different from the calculation when the strategy remains intact with all of the contemplated legs or positions. This is applicable to all options strategies inclusive of long options, short options and spreads. To learn more about Merrill's uncovered option handling practices, view Naked Option Stress Analysis (NOSA) (PDF).

Early assignment risk is always present for option writers (specific to American-style options only). Early assignment risk may be amplified in the event a call writer is short an option during the period the underlying security has an ex-dividend date. This is referred to as dividend risk.

Long options are exercised and short options are assigned. Note that American-style options can be assigned/exercised at any time through the day of expiration without prior notice. Options can be assigned/exercised after market close on expiration day. View specific Merrill Option Exercise & Assignment Practices (PDF).

Supporting documentation for any claims, comparison, recommendations, statistics, or other technical data, will be supplied upon request.

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