What is an Index Option?
Like stock options, index option prices rise or fall based on several factors, like the value of the underlying security, strike price, volatility, time until expiration, interest rates and dividends. But there are five important ways index options differ from stock options, and it’s important to understand these differences before you can start trading index options.
Difference 1: Multiple underlying stocks vs. a single underlying stock
Whereas stock options are based on a single company’s stock, index options are based on a basket of stocks representing either a broad or a narrow band of the overall market.
Narrow-based indexes are based on specific sectors like semiconductors or the financial industry, and tend to be composed of relatively few stocks. Broad-based indexes have many different industries represented by their component companies. But that doesn’t necessarily mean there are a ton of stocks that make up a particular broad index.
For instance, the Dow Jones Industrial Average is a broad-based index that’s only composed of 30 stocks, but it still represents a broad range of sectors. As you would expect, however, other broad-based indexes are indeed made up of many different stocks. The S&P 500 is a good example of that.
Difference 2: Settlement Method
When stock options are exercised, the underlying stock is required to change hands. But index options are settle in cash instead.
If you exercise a call option based on the S&P 500, you don’t have to buy all 500 stocks in the index. That would be ridiculous. The index value is just a gauge to determine how much the option is worth at any given time.
Difference 3: Settlement Style
As of this writing, all stock options have American-style exercise, meaning they can be exercised at any point before expiration. Most index options, on the other hand, have European-style exercise. So they can’t be exercised until expiration.
But that doesn’t mean that if you buy an index option, you’re stuck with it until expiration. As with any other option, you can buy or sell to close your position at any time throughout the life of the contract.
Difference 4: Settlement Date
The last day to trade stock options is the third Friday of the month, and settlement is determined on Saturday. The last day to trade index options is usually the Thursday before the third Friday of the month, followed by determination of the settlement value on Friday. The settlement value is then compared to the strike price of the option to see how much, if any, cash will change hands between the option buyer and seller.
Difference 5: Trading Hours
Stock options and narrow-based index options stop trading at 4:00 ET, whereas broad-based indexes stop trading at 4:15 ET. If a piece of news came out immediately after the stock market close, it might have a significant impact on the value of stock options and narrow-based index options. However, since there are so many different sectors in broad-based indexes, this is not so much of a concern.
Now for the disclaimer
All of these are very general characteristics of indexes. In practice, there are lots of small exceptions to these general rules. For example, the OEX (that’s the ticker symbol for the S&P 100) is one big exception. Although the OEX is an index, options traded on it have American-style exercise.
This table highlights a few of the general differences between index options and stock options. But make sure you do your homework before trading any index option so you know the type of settlement and the settlement date.