What are Index Options?

Index options are calls or puts where the underlying asset is a stock market index like Nifty 50 or the Dow Jones or the Heng Seng .

Index options enable derivative traders to bet on the direction or volatility on an entire equity market (or market segment) without having to trade option on all of the individual securities.

According to the Futures Industry Magazine ...................

Generally, the factors for the pricing of index options are the same as equity options with a European exercise. I.e the inputs of underlying price, strike price, interest rate, volatility, dividend, call or put are fed into the Black and Scholes pricing model to calculate the premium.

The main difficulty for traders pricing index options is the dividend estimate.

To calculate the dividend component correctly, an option trader will need to know all of the individual stock component dividends and weight them in proportion to each stocks weighting in the index basket. Large investment banks and hedge funds will have a research division to carry out this task. However, another way is to use a 3rd party source like Bloomberg who publishes the dividend yield for the index as calculated from all of the component stocks.

One way that I've seen trader's workaround this is to not use any dividend estimates at all and instead base their options on the front month futures contract (instead of the index itself) to determine the theoretical forward of the option. This works well for front month options based off a front month future. For back month options, traders will use the front month future as the base contract and apply an "offset" to the forward price used to reflect the carry cost from the front month to back month. Traders usually use the futures roll price from the front month to back month to determine this carry cost.

With this method index option traders are assuming that the index futures contract has already priced the dividends into the futures market price.

Are all index options European style exercise?

Almost. There are a few exceptions, like the OEX (CBOE: OEX), which are cash settled American style index options. A trader may exercise OEX options at any time prior to the expiration date and the amount to settle will be based upon the closing price of all of the component stocks on the day the trader exercises.

An American style index option with a physical settlement would be a nightmare for option clearing houses. Say you were long a call option on the S&P 500 index and decided during the day to exercise. Your broker would have to arrange with the clearing house for delivery of all 500 stocks in their correct weighting and price at the time of exercise to you. And the seller would then be short all 500 stocks.

One exception to this is the SPI. SPI options (Australian All Ordinaries Index) are referred to as index options, however, they are technically "futures options" as the underlying security for the options is the SPI future. SPI options are American exercise and exercise into the appropriate futures contract.

Expiration

Most index options are serial: March, June, September and December. The exceptions (AFAIK) are the Hang Seng and the KOSPI. HSI and KOSPI have options every month for the first 3 consecutive months and then serial months thereafter.

Settlement

As most index options are European exercised (exceptions are SPI/OEX) where physical delivery is not possible, settlement is always done in cash and will occur on the next business day after exercise.

Determining the settlement price differs from index to index and option traders will need to refer to the contract specifications to be sure what method will be used to determine the price.

For example, the settlement price used for the options on the KOSPI index is determined by the weighted average price of all of the component stocks in the last 30 minutes of trading on the final trading day. The NIKKEI 225 index options are settled according to the weighted average of the opening price of all of the component stocks the morning "after" the final trading day. Options on the FTSE index are settled basis the Exchange Delivery Settlement Price (EDSP) as reported by LIFFE on the last day of trading.

Index option traders eagerly await the final settlement price, which is reported by the exchange. It is referred to as The SQ (which I believe is Settlement Quote. I've also heard it referred to as Special Quotation...I'm not sure which expansion is correct).

Volatility Index Options

Another type of index option that is very popular to trade are options on Volatility Indexes.

More on Volatility Options.

Why Trade Index Options?

Diversification

Options based on indices rather than individual stocks provide investors with diversification.

In finance, a text book will tell you that diversification means the removal of unsystematic risk. However, if you've ever come across the saying “don’t put all your eggs in one basket” then you have already been introduced to the concept of diversification. It basically means spreading your investment across multiple assets, in this case, multiple stocks with the objective of reducing (or evening out) your overall risk.

A stock index is a compilation of many stocks. The S&P 500 is meant to resemble a portfolio made up of 500 individual companies. Index options based off the S&P 500 (SPX) give option traders the chance to construct option strategies and techniques to bet on the entire market rather than the performance of one individual stock.

Predictability

I don't mean to mention that index options are easy to predict. But index options are generally less volatile than the component stocks that make up the index.

Earnings reports, takeover rumors, news and other market events are what drive volatility in individual stocks. An index tends to smooth out the wild ups and downs of the stock basket and hence options based off an index will also show lower fluctuations.

Liquidity

Index options are very popular for option traders, hedge funds and investment firms. This popularity drives up the volumes available to trade and reduces the spreads quoted in the market. This competition means that you will always have a fair price to trade at and plenty of volume too.

Where to next?

http://www.amex.com/options/eductn/op_edu_whatIs_index_pg1.html

http://financial-dictionary.thefreedictionary.com/Index+option

http://www.cboe.com

Global Futures and Options Volume by Region

Exchange-traded derivatives based on equity indexes had the highest rise in volumes of any other type of derivatives. This category rose by 33%. Equity indices are accessible for retail investors, but there are also of interest to bigger investors.

FIA today released its half-year 2019 report on trading activity in the global exchange-traded derivatives market.

The total number of futures and options traded worldwide in the first half of the year reached 16.6 billion contracts, up 11% compared to the first half of 2018. Futures volume reached 9.3 billion contracts in the first half of the year, up 9% from the first half of 2018. Options volume reached 7.3 billion contracts, up 13%.

Open interest, which measures the number of outstanding contracts at a single point in time, stood at 884.6 million contracts at the end of June, up 4% from a year ago. More than two-thirds of those contracts were options.

FIA measures volume and open interest by the number of contracts traded and/or cleared on derivatives exchanges. The statistics are collected on a monthly basis from more than 80 exchanges worldwide.

Other significant highlights in today’s report:

Asia-Pacific and Latin America exhibit strong growth

Asia-Pacific was the largest region in terms of overall volume. The total number of futures and options traded on exchanges in that region reached 6.8 billion contracts in the first half of 2019, up 32% over the first half of 2018. Trading activity on Latin American exchanges also grew very rapidly, up 36% to 1.9 billion contracts in the first half of 2019.

Trading activity in North America and Europe moved in the opposite direction. The number of futures and options traded on exchanges in the U.S. and Canada declined 5% to 5.1 billion contracts in the first half of 2019. Volume on European derivatives exchanges declined 7% to 2.5 billion contracts in the first half of 2019.

Equity index volume up 23%, interest rate open interest up 24%

The fastest rate of growth was in the equity index sector, where volume rose 23% over the first half of 2018. The total number of equity index futures and options traded on exchanges in the first half of 2019 reached 5.9 billion contracts, 35% of the total industry-wide volume. Trading activity also grew rapidly in the energy and precious metals categories.

Trading activity in the interest rate category was roughly unchanged from the previous year, with total volume reaching 2.4 billion contracts. On the other hand, open interest in interest rate futures and options rose 24% to 211 million.

The non-precious metals category, which includes futures and options on copper, aluminum, steel, and other industrial metals, was the category that saw the greatest decline in trading activity. First-half volume was 694 million contracts, down 10% from the previous year. Open interest rose 6%, however, to 9.6 million contracts.

Exchange Ranking: India’s NSE surpasses CME in volume but not open interest

The National Stock Exchange of India continued its rapid growth in the first half of 2019. Trading volume on NSE jumped 67% to 2.7 billion contracts, driven mainly by increased trading of its equity index options. CME Group came in second with trading volume of 2.5 billion contracts in the first half of 2019, down 3% from the previous year.

Measured by trading volume, NSE was the largest derivatives exchange in the world in the first half of 2019, the first time in its history that it has ranked so high. Open interest tells a different story, however. NSE’s clearinghouse only had 8.3 million contracts in open positions at the end of June. In contrast, CME’s open interest at the end of June was 141 million contracts, second only to the OCC, which clears futures and options for six groups of U.S. exchanges.

Eurex ranked as the largest derivatives exchange in Europe in terms of both trading volume and open interest. Total volume in the first half of 2019 was 1 billion contracts, down 2% from the previous year. Open interest rose to 136 million contracts, up 9% over the previous year.

B3, Latin America’s largest exchange, continued to grow at a rapid rate. Total volume rose 35% to 1.8 billion, making it the third-largest exchange in the world by trading volume. Open interest rose 20% to 94 million contracts at the end of June, fourth largest in the world.

FIA provides its members with monthly reports on trading activity in the exchange-traded derivatives markets. FIA also publishes statistics on trading activity on swap execution facilities and customer funds held at futures commission merchants in the U.S. To access these statistics, visit the industry data page on the FIA website.