Index traders tend to think differently than stock traders. Since an index represents a basket of different companies, traders in this arena are more focused on market or sector trends, and less concerned about company-specific developments or news. Similar options strategies can be applied to both stocks and indexes. However, while the strategies are often the same, there are important differences between stock and index options that all index traders should understand.
An index can't be bought and sold. Unlike exchange-traded funds [ETFs] and stocks, there are no index shares listed for trading on the exchanges. Instead, an index is really a benchmark used to track the prices of a basket of stocks. Therefore, the only way to actually trade an index is with options. For example, the S&P 100 Index ($OEX) was the first index to have options linked to its performance. The OEX includes 100 of America's top companies and options started trading on the index in 1983.
Today, options traders have hundreds of indexes to choose from. Some are designed to track the broader market and others are created around specific sectors. Some of the actively traded indexes today include the S&P 500 Index ($SPX), the Dow Jones Industrial Index ($DJX), the mini-NASDAQ 100 Index ($NDX), the PHLX Gold and Silver Mining Index ($XAU), the PHLX Oil Service Index ($OSX), and the Russell 2000 Small Cap Index ($RUT). (Note that on our website, and many others, a $ sign precedes the index symbol. If there is no $ before the symbol, it is not an index but either a stock or an exchange traded fund.)
There are three different ways to construct an index. The capitalization or market-value weighted index is the most common. Using this methodology, the total market values of all companies are added together and the index value is computed using a divisor. The S&P indexes are computed using the cap-weighted method. The Dow Jones Industrial Average, on the other hand, uses the price-weighted methodology. The price-weighted method is similar to computing an arithmetic mean or average and gives greater weight to stocks with higher prices. The equal-dollar weighted method is often used when computing sector indexes. It gives each stock within the index an equal weight.
While there a variety of different indexes available to investors, the options contracts share some common characteristics. For one, since indexes can't be bought or sold and no shares actually trade, the settlement of index options is different than with ETFs or stocks. Namely, the options settle for cash, which is equal to the difference between the strike price of the option and the settlement value of the index. The settlement value is usually computed on the Friday before expiration Saturday and the last day to trade the options is therefore on Thursday.
Another important difference between stock and index options is that stock options settle American style, but most (not all) index options settle European style. American-style options can be exercised or assigned at any time prior to expiration. European-style options can only be exercised at expiration. So, there is no early-assignment risk for most cash settled index options.
Despite the differences, many of the strategies that are applicable to stock options can be used in the index market. Directional traders can use bearish or bullish debit spreads, neutral trades can create calendars or diagonals, or those expecting volatility to spike higher might look at straddles and strangles. An important difference, however, is that indexes offer more diversification and will generally be less volatile than individual stocks. Their options contracts will be priced accordingly (with lower levels of implied volatility.)
In addition to volatility, another important consideration is what affects the index. For example, the PHLX Oil Service Index will tend to move in reaction to changes in oil prices, the S&P 500 is highly influenced by macroeconomic trends, and the mini NASDAQ 100 is a play on high technology. Traders with specific knowledge or area tend to gravitate towards sector indexes where that knowledge can be applied. Others are more interested in broad economic trends and are more inclined to trade the SPX, OEX, or DJX.
In conclusion, once the trader has selected an index of interest, the next questions to ask include: 1) how many companies are in the index, 2) is it a market value, price, or equal-dollar value weighted index, 3) when is the last day to trade the options, and 4) does it settle European or American style. The answers to these questions and more can be found on the website of the exchange where these options trade, which includes the American Stock Exchange (amex.com), the Chicago Board Options Exchange (cboe.com), the Philadelphia Stock Exchange (phlx.com), or the International Securities Exchange (iseopions.com).
Senior Writer & Index Strategist
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