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What is Index Options Trading?

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Portfolio diversification is one of the many ways that investors use to protect themselves from risks that come with fluctuations in the market. Index options happen to be one of the ways through which investors can do this while increasing their return potential too. However, before incorporating this strategy, it is important to know how it works. 

Understanding Index Options Trading in Detail 

With the help of index options, investors gain access to unique opportunities to help them participate in broader markets or particular sectors via a single transaction. Index options are derivatives that are not based on individual stocks but on stock indices. The purpose of index option trading is to allow traders to buy or sell the option on the entire index. This helps benefit them from favorable movements across the entire market or even in a particular sector. With the help of index option trading, investors can spread their investments across several stocks in the same index and benefit from the diversification it offers. 

How Does Index Options Trading Work?  

In index options trading, traders analyze index movements without trading the underlying stock directly. With the help of index options, traders can speculate on the direction of an index. This method is very similar to how individual assets get traded. Index options back the underlying index and use index futures contracts to help with the pricing and settlement aspect of it.

Index option trading does not necessitate the delivery of underlying assets physically as the settlement in index options takes place in cash. With the help of a call option investors can purchase the index at a price agreed upon previously, or with the help of a put option, they can sell the index at a certain price. 

Both the potential profits and losses are capped when indulging in index options trading, offering investors low-risk opportunities. With a multiplier of mostly 100, index options help determine contract prices. With the help of index options, investors can protect portfolios during downturns. They can also use the options to hedge positions where there are larger, diversified portfolios involved. 

Types Of Index Options  

There are three ways in which index options can be divided:

  1. Index Put and Index Call Options: 

  2. When it comes to index options, index call options represent the right to buy an index, signifying a bullish view

  3. Conversely, index put options represent the right to sell an index and signify a bearish view

  4. In-the-Money, Out-the-Money and At-the-Money

  5. ITM or In-the-Money is the only one of the three options that are bound to give returns if and when exercised. 

  6. Nifty and Bank Nifty Index Options:

  7. The only index options that can be traded on the Indian capital markets are Nifty and Bank Nifty options

  8. These trades are carried out either weekly or monthly. 

  9. Weekly trades expire every Thursday while monthly options expire on the last Thursday of every month.

Example Of Index Option Trading  

Here are two examples of index option trading:

Example 1

  1. Let us suppose an investor purchases a call option on the Nifty 50 index believing that its value will increase significantly over the next few months.

  2. With the call option, the investor now has the right, without the obligation to buy the Nifty 50 index before or on the option’s expiration date, at a predetermined price. 

  3. This price is the option’s strike price.

  4. With the help of this call option, the investor can now benefit from any upward movement in the index

Example 2:

  1. Suppose an investor purchases a put option on the Nifty 50 index as they expect a potential decline. 

  2. Now the investor has the right to sell the Nifty 50 index without the obligation to do so, before its expiration at the predetermined strike price.

  3. This put option will protect the investor from potential losses if there is any significant decline in the index. 

Additional Read: Different Types of Futures

Key Characteristics Of Index Options Trading  

Some of the main characteristics of index options trading are listed below:

  1. European Style Exercise: 

    • In index options, the settlement happens only after the maturity or expiration of the option.

    • This is based on the European style of exercise

  2. Expiration Dates: 

    • Usually, index options come with serial expiration dates.

    • These expiration dates usually occur in March, June, September, and December.

    • The KOSPI option is an exception where it matures every month in the first three months and then follows the serial expiration pattern

  3. Cash Settlement:

    • As physical delivery of assets is not feasible, index options are settled via cash 

    • These payments are done a day after the option has been exercised. 

    • The settlement is determined and can vary based on the index or the exchange.

Advantages Of Index Options Trading  

Some of the main advantages of index option trading are listed below:

  • Index options trading offers traders tremendous market exposure as they gain access to the entire market index without investing in individual stocks. 

  • As a result, traders can gauge the overall market performance and diversify their portfolios accordingly.

  • Index options trading also offers a lot of flexibility to traders as they can choose everything from the time frame and the strike price to the investment strategy they want to use. 

  • Investors and traders can also choose whether they want short-term or long-term options based on their trading preferences.

  • Index options also provide hedging opportunities

Disadvantages Of Index Options Trading  

Where there are advantages, there are disadvantages too in index options trading. Here is a look at some of them:

  • Predicting the movement of an index can be difficult as index options get influenced by several factors like economic indicators, market sentiment, geopolitical events etc.

  • To make predictions profitable, traders need to understand each of these factors.

  • Traders often have to pay higher premiums for index options compared to individual stock options as index options provide broader market exposure. 

  • If the price movement is against the trader then they risk losing the entirety of the premium they paid in a short span.  

Additional Read: Benefits and Risks in Index Options Trading

Index Options Trading Strategies 

Listed below are some index options trading strategies:

  1. Covered Call: 

    • Here traders buy stocks and simultaneously sell a call option. 

    • This helps them generate income and reduces the risk of holding stocks. 

  2. Married Put: 

    • Here, investors purchase stock and simultaneously buy a put option 

    • This helps them in case there is a downside risk, as investors can still sell their shares at the put option’s strike price.

  3. Bull Call Spread: 

    • With the help of the bull call spread, traders can capitalize on any moderate price rises in the underlying asset. 

    • As a part of this strategy, investors buy call options at a specific strike price and sell the same number of call options at a higher strike price.

    • Though this limits the profit potential, it reduces the total premium spent across the transactions.

  4. Bear Put Spread:

    • When traders are expecting a fall in the value of the underlying asset, they invest in put options at a specific strike price and sell the same number of put options at a lower strike price. 

    • With this, investors profit from any downward movement in the asset’s price and limit their potential losses.

  5. Long Strangle: 

    • Here traders buy both call and put options at different strike prices. 

    • This strategy is employed when traders, though unsure of the direction, expect significant price movements in the market. 

    • The main aim of this option is to generate profits irrespective of the direction of the price movements during volatility. 

Index Options Trading Vs Stock Option Trading

Listed below are a couple of differences between index option trading and stock option trading.

Aspects

Index Option

Stock Option

Underlying Asset

In index options, the underlying asset is a stock market index

In the case of stock options, the underlying stocks are all individual stocks.

Market Exposure

Exposure to a broad market or specific sector

Explore only a single company

Exercise Style (Typically)

European which can only be exercised at expiration or maturation 

American which can be exercised at any time before expiration

Risk

Less individual stock risk due to diversified exposure

Exposure to stocks from the same company comes with a higher risk

Conclusion

The great thing about trading in stock options in India is that it is a regulated activity where both the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) provide various index options contracts to traders. These options are based on various Indian stock market indices. When done right, index options trading can prove to be very lucrative for traders who want to capitalise on the various market movements. However, investors need to understand the workings of these options to be able to successfully adopt them into their trading strategy and generate profits. 

Additional Read: Bearish Options Trading Strategies for Falling Markets

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Frequently Asked Questions

What is index option trading meaning?

Answer Field

Index options are derivatives that are based not on individual stocks but on stock indices. The purpose of index option trading is to allow traders to buy or sell the option on the entire index. As a result, investors can benefit from favorable movements across the entire market or even in a particular sector

How does index option trading work?

Answer Field

In index options trading, traders analyze index movements without trading the underlying stock directly and speculate on the direction of an index. Index options back the underlying index and use index futures contracts to help with the pricing and settlement aspect of it.

What are the benefits of index option trading?

Answer Field

Index options trading provides traders access to the entire market index without investing in individual stocks and helps them diversify their portfolios accordingly. Traders can choose everything from the time frame and the strike price to the investment strategy they want to use in index options trading and whether they want short-term or long-term options based on their trading preferences.

What is the difference between index options and stock options?

Answer Field

Index options trading follows the European style of exercising while stock options use American. Index options have stock indices as the underlying stocks as compared to individual stocks in stock options. Because of the diversification in index options trading, it holds less risk when compared to stock options.

How are index options settled?

Answer Field

The settlement of index options takes place through cash as physically delivering assets is not a feasible option.

What are the risks involved in index option trading?

Answer Field

Index options trading comes with its fair share of risks like limited gains, time decay, and market volatility.

Which strategies are best for index option trading?

Answer Field

There are many strategies for index option trading. Some of these include covered call, bull call spread, married put, bear put spread and the long strangle 

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