Index options represent, by far, one of the most accessible ways for beginners to get broader market exposure. This article clarifies what index options are (meaning stock index options). Discover the advantages of stock index options trading, including liquidity and cost-effectiveness, compared to trading individual stocks or ETFs.
Key takeaways
- Index options are derivatives that give traders exposure to the broader market with lower capital compared to, for example, ETFs.
- Index options are generally more liquid than stock options, and it is possible to find options with daily expirations on some popular index-based ETF options.
What Are Index Options?
So, what are index options? At their core, index options are financial derivatives that provide the right, but not the obligation, to buy or sell the value of an underlying stock index. Unlike stock index options that reference individual stocks, index options focus on a benchmark index, like the S&P 500, offering broad market exposure.
How Index Options Work
Index options trading involves buying and selling options based on the value of an index. These options are cash-settled, meaning no physical assets are exchanged when the option is exercised. Instead, any profit or loss is settled in cash. This feature makes them ideal for traders seeking to speculate or hedge without directly purchasing the underlying stocks.
Example of Index Options Trading
Let’s see a quick theoretical example to illustrate how equity index options work:
- Hypothetical Index: Imagine an index called Index ABC with a price level of $600.
- Call Option Purchase: An investor buys a call option on Index ABC with a strike price of $610.
- Option Pricing: This call option is priced at $15, making the contract cost $1,500 (or $15 times a 100 multiplier).
By purchasing the option for $1,500, the investor is basically using a leveraged strategy on ABC. Without options, the same type of exposure would have required a substantial amount of money ($600 times 100, so $60,000). In this way, traders can allocate the remaining $58,500 elsewhere.
The risk in this trade is limited to the $1,500 premium paid. The break-even point is the strike price plus the premium, or 625 (610 + 15). If the index reaches 640 at expiration, the option holder exercises it, receiving $3,000 in cash (because (640 – 610) x $100 = $3,000), resulting in a net profit of $1,500 after subtracting the initial premium.
Why Would You Buy Index Options?
Even just when looking at our simple theoretical example above, there are a few aspects you cannot ignore about equity index options:
- Main Purpose: Ideal for speculating on market direction or hedging investment portfolios (remember: in our example, with a bullish outlook, you would have bought a call).
- Flexibility: Index options allow investors to leverage market movements without owning individual stocks (again, in our example, you only invested $1,500 instead of $60,000 to gain the same exposure to the underlying index).
- Risk Management: Losses are limited to the premium paid (back to our example, you would have never lost more than $1,500 in a bearish scenario).
As a small note, consider that Option Samurai provides tools to screen ETF options (like this covered call page), enabling investors to gain exposure to equity indexes via options like SPY or QQQ. This capability offers a flexible approach to achieving similar market exposure as directly trading index options.
An Index Options Example from Real-Market Trading
We will show you how a typical equity index options trade works through our options screener. Remember, Option Samurai provides the capability to screen options with index-based ETFs as their underlying assets, offering exposure similar to traditional index options.
Let’s say you’re optimistic about the S&P 500’s future movements. You decide to look for opportunities to trade the SPY ETF. Currently, SPY is trading at $561.40, and our options screener identifies an unusual surge in trading volume for the $582 call option expiring next week.
Analyzing the Trade on SPY
This is what you’d find on the screener:
From the image above, you should notice at least these two things:
- Bid-Ask Spread: The bid-ask spread for this option is just $0.01 (bid = $0.14, ask = $0.15). This tight spread highlights one of SPY’s advantages: its high liquidity on most expiration dates, ensuring efficient trading.
- Profit and Loss (P&L) Chart: For this long call strategy, you need SPY to close above $582.15 to make a profit. Your potential loss is limited to the $15 premium paid, while the profit potential is unlimited and increases linearly with SPY’s price rise.
Understanding the Trade Dynamics
The option is currently cheap because it is significantly out-of-the-money (OTM). However, the heavy trading volume suggests that investors anticipate a notable upward move in SPY’s price in the coming days.
This doesn’t guarantee a price surge, but it reflects a market sentiment worth considering. Interestingly, even seasoned institutional investors can often misjudge market movements, proving that “smart money” isn’t infallible.
In fact, you should probably consider the historical price of SPY to get a better view of the trade you’re evaluating:
With a big volume on the $528 call, the market seems to be wagering on a continuation of the bullish trend in the short term.
Should You Take This Trade?
That’s the one-million-dollar question. Or, rather, the fifteen-dollar question. If this trade aligns with your market outlook, it might be a sensible risk. With only a $15 investment, it remains a manageable risk without messing up your portfolio balance.
If you choose to focus on trading volume, you are trying to follow what the “smart money” is doing. The thing is, smart money is not exceptionally “smart” per se, but it is very fast at adapting to changing market conditions. The sudden spike in trading volume on the $582 call does not mean that SPY will close above $582 next Friday, but it does suggest that something could be developing under the surface.
More realistically, you could consider closing this trade earlier if SPY really moves up over the next 1-2 days. You don’t even need SPY to hit $582.15: you can just close the trade earlier if, say, SPY reaches $575. Turning $15 into $50 in two days is a great rate of return, and by that time, you could check what the smart money is doing next.
Once again: smart money moves fast, and what is heavily traded today could be stale tomorrow. If, for instance, you find a volume peak in the $570 put in 3 days, that could be the new market focus for some reason.
While you cannot rely on trading volume alone as a trading signal, it can help guide your decisions if it aligns with your broader market outlook. What you should take away here is that a) Yes, you can trade options on indexes, b) Yes, trading options on index-based ETFs can be a valid alternative to options directly on volatility, and c) Trading volume is just one of the many factors you should consider in your trading analysis.
Pros and Cons of Trading Index Options
You have probably already noticed how some of the pros and cons of trading stock index options popped out in our example on SPY. To add even more clarity, let’s explore these factors further. The table below summarizes the advantages and disadvantages of trading equity index options:
Pros of Trading Index Options
- Invest in the Overall Market: Index options are a great way to gain exposure to the entire market. They reduce company-specific risks by focusing on the overall market movement rather than individual stocks. This is particularly useful for investors who want to hedge their portfolios or speculate on broad market trends.
- Daily Expirations: Many popular ETFs, like SPY, offer options with daily expirations. This allows traders to take advantage of short-term market movements with precision.
- High Liquidity: Stock index options, especially on major ETFs, tend to have high trading volumes. This high liquidity often results in tighter bid-ask spreads, which can enhance trading efficiency and reduce transaction costs.
Cons of Trading Index Options
- Limited Differentiation: Adding index options to a portfolio can make it hard to differentiate trades. For example, QQQ, which tracks tech companies, obviously tends to move in tandem with most tech stocks, reducing the diversity of trading strategies. In this sense, trading SPY may be a better idea.
- Market Sentiment Sensitivity: Options on volatility indexes like the VIX are extremely sensitive to changes in market sentiment. This can lead to significant volatility in option prices, which might not align with broader market movements.
- Missing out on Company-Specific Gains: Index options do not capture the potential gains of individual companies. So, if a specific company experiences significant growth, your stock index options trade may not benefit.
