What is index option?
First, let us understand what options are before we get to index options. Options are rights to buy or sell an underlying asset at a fixed price, also called the strike price, on a preset date in future, which is the date of contract expiration. In India, options expire on last Thursday of every month. The underlying securities could be anything from stocks, bonds, commodities, interest rate futures, or stock index. Options are named after the underlier like stock options, index options, future options, and commodity options, among others.
Index Option Definition
In index options, the underlying asset is an index. It could be a stock index like the S&P 500, for example. Index options allow traders to take hedged exposure to all the company stocks or an entire market segment that are part of the index instead of taking bets on individual company shares.
Index option gives the owner the right to buy or sell exposure to indices as an underlying asset at a predetermined price on a fixed future date (last Thursday of every month).
Based on when the transaction can be executed, there are two types of index options- American and European options. In American options, the owner has the right and freedom to buy or sell the index By a specific date at a preset price. Unlike in American options, the European index options do not give a wider time frame for selling or buying a stock at a pre-decided price. In other words, while in American options, you can exercise your buying or selling right before expiration, in European-styled index options, you can only exercise the right on the specific date. In India, all the options traded are European styled, and these contracts expire by last Thursday of every month. This is so because trading index options in American style would be a real nightmare for clearing houses given the trading volumes.
Two types of Index Options in India
What is an index call option?
A call option gives the owner a right to buy a given quantity of an underlying asset, a stock index in this case, at a fixed price on the date of the expiry of the contract. The buyer of an option is said to go long on an option.
How does an index call option work?
For example, if trader M is bullish and expects the current prices of say Nifty50 index to settle at a higher price band of say Rs.13,000-Rs.14,000 eventually, he will prefer to lock in the price of the stock when it is low by trading index options. If the spot price is Rs. 12,000 per lot, given his expectations of a rise in index price, he could enter into trading index options by buying a one-month European call option on Nifty50 at a strike price of Rs.12,500. This includes payment of a premium to the underwriter which will be pocketed by the seller or underwriter.
Scenario 1
Now on the day the contract expires, M finds the spot price of Nifty50 trading at Rs. 13,200. Trader M will be said to be In The Money, as the strike price of his index option contract would be lower than the spot price of the index. This difference of Rs.700 between the strike price and the current price is the intrinsic value. M gets to keep as profit on exercising his right to sell the index at the strike price.
Scenario 2
But what if the current price of Nifty50 on the day of contract expiry trails at Rs. 12,200? In that case, when the strike price is higher than the spot price of the index, the buyer of the option will decline to exercise his right of purchasing the underlying index at the strike price. In that case, the real loss would be limited to the premium amount he paid for the contract; and the option contract would be rendered worthless.
What is an index put option?
A put option on an underlying index is the right to sell the underlier at a set price on a specific date, or the expiration date. The seller or writer of an option contract is said to be short on an option.
How does an index put option work?
Let us consider an example of a European put index option.
Suppose trader N is bearish and expects spot prices of Nift50 index to fall dramatically in a month, he would like to hedge his price risks by getting into a put option contract. A put option contract allows N to exercise his right to sell the underlying index at a pre-decided price on the day the contract expires. If the spot price of Nifty50 index is at Rs.12,000 and trader N expects this price to go down, he would enter a put options contract at a mutually decided price of say Rs. 11,500 per lot.
On the day the contract expires, if the spot price of Nifty50 is anywhere less than the strike price of Rs.11,500, let’s assume at Rs.10,500, trader N can execute his right to sell the underlying stock at the pre-decided price of Rs. 11,500, making a decent profit of Rs.1000, which is the intrinsic value or the difference between the strike price and spot price of the underlying index.
But if on the day the option contract expires, the spot price of Nifty50 is higher than the strike price of Rs.11,500, at say Rs.12,500, then trader N will choose not to execute his right to sell at the strike price lower than the spot market price of the index. In that case, the trader would be said to be Out of The Money by Rs.1000. He will let the contract expire worthless by limiting his loss to the amount of premium paid by him.