Stock indices are weighted groups of stocks whose overall performance is used as a benchmark for the stock market or part of it. The S&P 500, for example, is a group of the 500 largest US stocks weighted by market capitalization and is one of the most popular benchmarks against which investors compare the performance of their own portfolios.
Because indexes are theoretical and not actual stock funds, investors cannot buy shares from them directly – that’s where index options come in.
What are index options?
Index options are options contracts that give their holder the right to buy or sell the value of an underlying stock index at a specified strike price on a specific expiration date. Index options, like regular individual stock option contracts, are derivative securities because they derive their value from an underlying instrument — in this case, a stock index such as the Nasdaq Composite or Russel 2000.
Like a normal options contract, an index option can be either a buy or a sell. Calls allow holders to buy the value of an index at the specified strike price, while puts allow holders to sell the value of an index at the specified strike price. An investor who is bullish on the index (thinks it will rise in value) might buy a call option, while an investor who is bearish on the index (believes it will go down in value) might buy a put option.
How do index options differ from regular options contracts?
Index options are very similar to typical options contracts, but they differ in several important respects:
- While the value of a typical options contract varies based on the price of a single underlying share, the value of an index option varies based on the price level of an entire stock index made up of many different shares.
- Typical options contracts can be exercised at any time prior to expiration (in the US), while most index options can only be settled on their expiration date (similar to European-style options).
- When ordinary options contracts are exercised, their holder buys or sells the underlying shares at the strike price, whereas when index options are exercised, they are cash settled, as there are no underlying shares physically attached to the contract.
How do index option multiples work?
Like traditional options contracts, which are usually for the purchase or sale of 100 shares, index options usually come with a multiplier of 100.
This means that if the listed premium (sale price) of an index option is $200, then the total contract will cost $20,000 to buy, and the price change of the underlying index will also multiply by 100 for the contract’s cash settlement at expiration. , if practiced.
Below is an example of how this process works.
Example of buying and exercising index options
Let’s say an investor wanted to bet on the future price movement of a fictitious stock market index called Index XYZ, which is currently valued at $18,500. The investor believes that the value of the index will increase over the next few months, so they want to buy a call option. Here’s what an index options contract might look like:
- Spot price for the index: $18,500
- Index option strike price: $19,000
- Index option premium: $200
- Index option multiplier: 100
- Total contract cost: $20,000
- Contract expiration: two months
If, in two months’ time, the value of Index XYZ is $19,500, the investor will exercise his index option contract and receive a cash payout of $50,000 (the index’s current spot price of $19,500 minus the contract’s strike price of $19,000 times a multiple of 100). Since the investor initially paid $20,000 (contract premium of $200 multiplied by a multiplier of 100), he would make a profit of $30,000.
How are capital gains from index options taxed?
Regular options contracts always expire a year or less after the date they were written, so any capital gains an investor incurs from them are taxed at the short-term capital gains rate, which is higher (lower interest) than the long-term rate.
On the other hand, capital gains incurred through broad-based index options are considered a tax advantage – they qualify as Section 1256 contracts and are therefore subject to what is known as the “60/40 rule.” This means that 60% of the gains from an index option are taxed in the long term, and the remaining 40% of the gains are taxed in the short term.
For example, because the investor in the above example made $30,000, $18,000 of this would be taxed at the lower, long-term capital gains rate, and the remaining $12,000 would be taxed at the higher, short-term capital gains rate.
Where can you buy and sell index options? Do they trade on stock exchanges?
Several index options are traded via the Chicago Board Options Exchange (CBOE). a List of tradable index options Available on the company’s website.