Index Option Concepts

For the sake of simplicity, taxes, commissions and other trading costs have been omitted from the discussion; these should be taken into account when making your investment decisions. The discussions are based on hypothetical situations and should only be considered as examples of potential trading approaches.

Index Option Concepts

As an investor, you may be familiar with options on individual stocks, where you have the right to buy (call option) or the right to sell (put option) a particular stock at some predetermined price within some predetermined time. The buyer has the rights and the seller the obligations. With index options the basic ideas are the same. However, index options allow you to make investment decisions on a specific market industry or on the market as a whole. Investment strategies can be made with index options similar to those made with individual stock options.

There are two types of index options:

An index call option gives the buyer the right to participate in market gains over and above a predetermined strike price until the contract's expiration. The buyer of an index call option has unlimited profit potential tied to the strength of the indexes advances.

An index put option gives the buyer the right to participate as the underlying index falls below a predetermined strike price until the contract's expiration. The buyer of an index put option has substantial profit potential in the event of a downturn.

In exchange for these "rights," the buyer pays the seller a price known as the premium for the option. Index options are traded and quoted in points and fractions. If an option is trading at 5.125 (5.125), the buyer would pay $100 times the premium quote, or $512.50 per option. The buyer's risk is limited to the amount of the premium. The seller of an option receives the premium from the buyer; this premium is the maximum profit a seller would realize from the sale of the option. The potential for losses in option selling is generally unlimited; any investor considering selling options should recognize that there are significant risks involved.

Index options have strike prices that are set at intervals from one to ten points. The relationship of the index to the option's strike price determines whether the option is referred to as in-the-money, at-the-money or out-of-the-money. A call option is in-the-money when the index level is above the strike price. It is at-the-money when the index level is equal to the strike price and out-of-the-money when the index level is below the strike price. If you bought an index put with a strike price of 75.00, you participate in moves in the underlying index below 75. A put option is in-the-money when the index level is below the strike price, at-the-money when the index level is at the strike price and out-of-the-money when the index level is above the strike price. CBOE will typically list in-, at- and out-of the-money strike prices. New strike prices are added in response to market movement in the underlying index.

In the case of a call, if the underlying index is above the strike price, the buyer may exercise and receive the amount by which the call is in-the-money at expiration. For example, with the settlement value of the index at 79.55, the buyer of a call with a 78.00 strike price would exercise and receive $155 [(79.55 - 78.00) x $100 = $155](see chart below). The seller of the option would pay the buyer this cash amount. Results vary, based on the settlement value at expiration. Settlement value, in this example, is calculated based on the opening prices of the component stocks on the last business day prior to expiration. Your call break-even point is an index level equal to the strike price plus the premium. The higher the the underlying index settlement value is above the break-even point at expiration, the higher your profit. If the settlement value at expiration is under the break-even point, however, you lose all or part of the premium. The maximum you can lose, as a buyer, is the amount of the premium.

Settlement Value of the index: 79.55 Index Call in-the-money Index call strike price 78 Settlement value 79.55 Difference 1.55 Multiplier x100 Cash value of call $155 Index Put out-of-the-money Index put strike price 78 Settlement value 79.55 Difference put has no value Multiplier x100 Cash value of put $0

Settlement Value the index: 74.88 Index Put in-the-money Index put strike price 78 Settlement value 74.88 Difference 3.12 Multiplier x100 Cash value of put $312 Index Call out-of-the-money Index call strike price 78 Settlement value 74.88 Difference call has no value Multiplier x100 Cash value of call $0

In the case of a put, if at expiration the index is lower than the strike price, the holder may exercise and receive the in-the-money amount. For example, with the settlement value of 74.88, the buyer of a put with a 78.00 strike price would exercise and receive $312 [(78.00 - 74.88) x $100 = $312] (see chart above). Again, the amount of profit or loss is determined by how much lower the underlying index is than the strike price at expiration, with the maximum loss being the premium amount. Your put break-even point is an index level equal to the strike price less the premium paid.

Index options are cash-settled, meaning no actual stocks are ever bought and sold on behalf of the option buyer. Index options can have a European-style or American-style exercise. European-style index options can be exercised only at expiration while American-style index options can be exercised at any time prior to expiration. From the perspective of an option seller, it is impossible to be assigned an exercise notice on a European-style option until the option's expiration. Index options are expiring assets in that they do not provide "rights" to the buyer indefinitely. Unlike stocks, which buyers can hold forever if they choose, index options expire or cease to exist on the expiration date. The buyer can choose from several expiration dates, depending upon his investment objective and the timing of his market forecast. Expirations are available up to three near-term months plus up to three months on the March quarterly cycle (for example, October, November, December, March, June, September). Index options can be either held until expiration or sold on the floor of CBOE during regular trading hours.

Take the Long-Term View with YZX LEAPS

On October 5, 1990, CBOE designed Equity LEAPS® - Long-term Equity AnticiPation Securities® - as a response to investors' desire for options with longer-term expirations. The development of LEAPS was an immediate success, appealing to both options and stock users.

LEAPS are long-term options with an expiration date as far as three years in the future that allow investors to establish long or short positions. This longer time period until expiration impacts time decay in an important way. Time decay is a term used to describe how the theoretical value of an option "erodes" or declines with the passage of time. With a longer exercise term, investors can utilize the time value inherent in LEAPS until it converts into a shorter-term option and is increasingly impacted by time decay (see chart above).

Today, CBOE lists LEAPS on equities, indexes and interest rate products. With LEAPS based on The Dow, investors may take a long-term position in the stock market with quantified risk at a fraction of the cost of purchasing shares of stock. Since the investment time frame of LEAPS is much longer than that of standard YZX options, investors need not predict the precise timing of the market movements - they need only correctly predict market trends over time. And like all options transactions, the buyer's risk is limited to the amount of the premium paid. Now, investors can capitalize on their long-term forecasts for the market, up to three years in the future, with one transaction.

 What Affects Index Options Prices?
There are several factors that affect the overall level of index option prices - the underlying index's value, the option's strike price, time until expiration, volatility, interest rates and dividends.

The prices of index calls and puts prior to expiration reflect both intrinsic value and time value. The most important consideration is the index value compared to the strike price of the option. This determines whether the option is in- or out-of-the-money. A call or put that is in-the-money has intrinsic value - the amount the holder would receive upon exercise. The intrinsic value of a 75.00 strike YZX index call is $2.50 if the underlying index is at 77.50 (77.50 - 75.00 = 2.50). Similarly, the intrinsic value of a 75.00 strike YZX index put is $3.25 if the underlying index falls to 71.75 (75.00 - 71.75 = 3.25).

The time value of the option consists of the traded price less the intrinsic value. If a 75.00 strike YZX call is trading at 4.25 with the underlying index at 77.50, then its intrinsic value is $2.50 (77.50 - 75.00 = 2.50), and its time value is 1.75 (4.25 - 2.50 = 1.75). Out-of-the-money options have no intrinsic value and thus their premiums reflect pure time value.

Index call and put prices are directly related to the amount of time remaining prior to expiration. Other factors being equal, the longer the period to expiration, the higher the price of the option. One exception to this may be a YZX deep in-the-money put.

Like the market as a whole, YZX option prices are affected by the level of interest rates. Other factors being equal, the higher the interest rate, the higher the call price and the lower the put price.

Volatility levels in the market also affect index call and put prices. Volatility is expressed as an annual percentage such as 15 or 20 percent, which is a statistical measure of how much the market is expected to move in a year. The amount of volatility in the marketplace, and underlying index in particular, is influenced by many economic and political factors such as investors' expectations of changes in inflation, unemployment, interest rates, war and technology. It is important to understand that during any trading day, the consensus among traders and investors on an estimate of future volatility is dynamic and can change frequently and abruptly. More information on volatility follows in the next section.

Increases in dividends or the dividend yield of the underlying index generally result in lower call prices and higher put prices.

Volatility

 With regard to stock prices and stock index levels, volatility is a measure of changes in price expressed in percentage terms without regard to direction. This means that a rise from 200 to 202 in one index is equal in volatility terms to a rise from 100 to 101 in another index, because both changes are 1 percent. Also, a 1 percent price rise is equal in volatility terms to a 1 percent price decline. While volatility simply means movement, there are four ways to describe this movement:

1. Historic volatility is a measure of actual price changes during a specific time period in the past. Mathematically, historic volatility is the annualized standard deviation of daily returns during a specific period. CBOE provides monthly historical volatility data for obtainable stocks in the Data section of the site.
2. Future volatility means the annualized standard deviation of daily returns during some future period, typically between now and an option expiration. And it is future volatility that option pricing formulas need as an input in order to calculate the theoretical value of an option. Unfortunately, future volatility is only known when it has become historic volatility. Consequently, the volatility numbers used in option pricing formulas are only estimates of future volatility. This might be a shock to those who place their faith in theoretical values, because it raises a question about those values. Theoretical values are only estimates, and as with any estimate, they must be interpreted carefully.
3. Expected volatility is a trader's forecast of volatility used in an option pricing formula to estimate the theoretical value of an option. Many option traders study market conditions and historical price action to forecast volatility. Since forecasts vary, there is no specific number that everyone can agree on for expected volatility.
4. Implied volatility is the volatility percentage that explains the current market price of an option; it is the common denominator of option prices. Just as p/e ratios allow comparisons of stock prices over a range of variables such as total earnings and number of shares outstanding, implied volatility enables comparison of options on different underlying instruments and comparison of the same option at different times. Theoretical value of an option is a statistical concept, and traders should focus on relative value, not absolute value. The terms "overvalued" and "undervalued" describe a relationship between implied volatility and expected volatility. Two traders could differ in their opinion of the relative value of the same option if they have different market forecasts and trading styles.

CBOE Volatility Index® - VIX®

One measure of the level of implied volatility in index options is CBOE's Volatility Index, known by its ticker symbol VIX. It is used by some traders as a general indication of index option implied volatility. Implied volatility levels in index options change frequently and substantially. Consequently, when trading short-term index options, traders should forecast the index level, the time period, and the volatility level. Traders of long-term index options should also include a forecast of interest rates. (The volatility discussions above are excerpts from the book Trading Index Options by James B. Bittman. This book is available through our online bookstore.)