«January 2001 Table of Contents Introduction 3 Benefits of Listed Index Options 5 What is an Index Option? 7 Equity vs. Index Options 9 Pricing ...»
UNDERSTANDING INDEX OPTIONS
Table of Contents
Benefits of Listed Index Options 5
What is an Index Option? 7
Equity vs. Index Options 9
Exercise & Assignment s AM and PM Settlement s American vs. European Exercise s Exercise Settlement s Closing Transactions s Basic Strategies 15 Buying Index Calls s Buying Index Puts s Glossary 21 For More Information 26 This publication discusses exchange-traded options issued by The Options Clearing Corporation. No statement in this publication is to be construed as a recommendation to purchase or sell a security, or to provide investment advice. Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options.
Copies of this document may be obtained from your broker, by calling 1-888-OPTIONS, or by visiting www.888options.com. A prospectus, which discusses the role of The Options Clearing Corporation, is also available without charge upon request addressed to The Options Clearing Corporation, 440 S. LaSalle St., Suite 908, Chicago, IL 60605, or to any exchange on which options are traded.
January 2001 Introduction The purpose of this booklet is to provide an introductory understanding of index options and how they can be used. Index options are currently traded on the following U.S. exchanges: The American Stock Exchange, L.L.C. (AMEX), the Chicago Board Options Exchange, Inc. (CBOE), the Pacific Exchange, Inc. (PCX) and the Philadelphia Stock Exchange, Inc. (PHLX). Like trading in stocks, options trading is regulated by the Securities and Exchange Commission (SEC).
These exchanges seek to provide competitive, liquid and orderly markets for the purchase and sale of standardized options. All option contracts traded on U.S. securities exchanges are issued, guaranteed and cleared by The Options Clearing Corporation (OCC). OCC is a registered clearing corporation with the SEC and has received a ‘AAA’ rating from Standard & Poor’s Corporation. The ‘AAA’ rating relates to OCC’s ability to fulfill its obligations as counterparty for options trades.
As referred to in this booklet, an index is a measure of the prices of a group of securities or other interests. Although indexes have been developed to cover a variety of interests such as stocks and other equity securities, debt securities and foreign currencies, and even to measure the cost of living, indexes on equity securities (which are called stock indexes) are among the most familiar. The following discussion refers only to stock indexes and stock index options.
Stock indexes are compiled and published by various sources, including securities markets. An index may be designed to be representative of the stock market of a particular nation as a whole, securities traded in a particular market, a broad market sector (e.g., industrials) or a particular industry (e.g., electronics). Indexes may be based on securities traded primarily in U.S. markets, securities traded primarily in a foreign market or a combination of securities whose primary markets are in various countries. An index may be based on the prices of all or only a sample of the securities whose prices it is intended to represent.
Readers who intend to trade index options should familiarize themselves with the basic features of the underlying indexes, including the general methods of calculation. Readers who are attempting to follow a precise and sophisticated strategy involving index options may wish to inform themselves about the exact method for calculating each index involved. Information regarding the method of calculation of any index on which options are traded, including information concerning the standards used in adjusting the index, adding or deleting securities and making similar changes is generally available from the options market where the options are traded.
While this discussion will focus on general characteristics of index options, specific classes of index options can have slightly different product specifications. Before investing, you should determine the specific terms of each product class. This and other information on index options or option products not included in this booklet can be obtained by contacting the appropriate exchange or The Options Industry Council (OIC) (see pages 26 and 27 for addresses, phone numbers and Web sites). In addition, OCC publishes a booklet, Understanding Stock Options, which covers the basics of exchange-listed equity options and is recommended to investors contemplating the use of index options. This book can also be obtained either by calling 1-888-OPTIONS or by visiting OIC’s Web site, www.888options.com.
This introductory booklet should be read in conjunction with the basic option disclosure document, Characteristics and Risks of Standardized Options, which outlines the purposes and risks of option transactions. Despite their many benefits, options are not suitable for all investors. Individuals should not enter into option transactions until they have read and understood the risk disclosure document which can be obtained from their broker, by calling 1-888-OPTIONS, or by visiting www.888options.com. It must be noted that despite the efforts of each exchange to provide liquid markets, under certain conditions it may be difficult or impossible to liquidate an option position.
Please refer to the disclosure document for further discussion on this matter. In addition, margin requirements, transaction and commission costs and tax ramifications of buying or selling options should be discussed thoroughly with a broker and/or tax advisor before engaging in option transactions.
Note: For the sake of simplicity, the calculations of profit and loss amounts in this booklet do not account for the impact of commissions, transaction costs and taxes.
Benefits of Listed Index Options Like equity options, index options offer the investor an opportunity to either capitalize on an expected market move or to protect holdings in the underlying instruments. The difference is that the underlying instruments are indexes. These indexes can reflect the characteristics of either the broad equity market as a whole or specific industry sectors within the marketplace.
Diversification Index options enable investors to gain exposure to the market as a whole or to specific segments of the market with one trading decision and frequently with one transaction. To obtain the same level of diversification using individual stock issues or individual equity option classes, numerous decisions and transactions would be required. Employing index options can defray both the costs and complexities of doing so.
Predetermined Risk for Buyer Unlike other investments where the risks may have no limit, index options offer a known risk to buyers.
An index option buyer absolutely cannot lose more than the price of the option, the premium.
Leverage Index options can provide leverage. This means an index option buyer can pay a relatively small premium for market exposure in relation to the contract value. An investor can see large percentage gains from relatively small, favorable percentage moves in the underlying index. If the index does not move as anticipated, the buyer’s risk is limited to the premium paid. However, because of this leverage, a small adverse move in the market can result in a substantial or complete loss of the buyer’s premium. Writers of index options can bear substantially greater, if not unlimited, risk.
Guaranteed Contract Performance An option holder is able to look to the system created by OCC’s Rules and Bylaws (which includes the brokers and Clearing Members involved in a particular option transaction) and to certain funds held by OCC rather than to any particular option writer for performance. Prior to the existence of option exchanges and OCC, an option holder who wanted to exercise an option depended on the ethical and financial integrity of the writer or his brokerage firm for performance. Furthermore, there was no convenient means of closing out one’s position prior to the expiration of the contract.
OCC, as the common clearing entity for all exchange-traded option transactions, resolves these difficulties. Once OCC is satisfied that there are matching orders from a buyer and a seller, it severs the link between the parties. In effect, OCC becomes the buyer to the seller and the seller to the buyer. As a result, the seller can buy back the same option he has written, closing out the initial transaction and terminating his obligation to deliver cash equal to the exercise amount of the option to OCC. This will in no way affect the right of the original buyer to sell, hold or exercise his option. All premium and settlement payments are made to and paid by OCC.
What is an Index?
A stock index is a compilation of several stock prices into a single number. Indexes come in various shapes and sizes. Some are broad-based and measure moves in broad, diverse markets. Others are narrow-based and measure more specific industry sectors of the marketplace. Understand that it is not the number of stocks that comprise the average that determine if an index is broad-based or narrow-based, but rather the diversity of the underlying securities and their market coverage. Different stock indexes can be calculated in different ways. Accordingly, even where indexes are based on identical securities, they may measure the relevant market differently because of differences in methods of calculation.
Capitalization-Weighted An index can be constructed so that weightings are biased toward the securities of larger companies, a method of calculation known as capitalizationweighted. In calculating the index value, the market price of each component security is multiplied by the number of shares outstanding. This will allow a security’s size and capitalization to have a greater impact on the value of the index.
Equal Dollar-Weighted Another type of index is known as equal dollarweighted and assumes an equal number of shares of each component stock. This index is calculated by establishing an aggregate market value for every component security of the index and then determining the number of shares of each security by dividing this aggregate market value by the current market price of the security. This method of calculation does not give more weight to price changes of the more highly capitalized component securities.
Other Types An index can also be a simple average: calculated by simply adding up the prices of the securities in the index and dividing by the number of securities, disregarding numbers of shares outstanding. Another type measures daily percentage movements of prices by averaging the percentage price changes of all securities included in the index.
Adjustments & Accuracy Securities may be dropped from an index because of events such as mergers and liquidations or because a particular security is no longer thought to be representative of the types of stocks constituting the index. Securities may also be added to an index from time to time. Adjustments to indexes might be made because of such substitutions or due to the issuance of new stock by a component security. Such adjustments and other similar changes are within the discretion of the publisher of the index and will not ordinarily cause any adjustment in the terms of outstanding index options. However, an adjustment panel has authority to make adjustments if the publisher of the underlying index makes a change in the index’s composition or method of calculation that, in the panel’s determination, may cause significant discontinuity in the index level.
Finally, an equity index will be accurate only
to the extent that:
s the component securities in the index are being traded s the prices of these securities are being promptly reported s the market prices of these securities, as measured by the index, reflect price movements in the relevant markets.
Equity vs. Index Options An equity index option is an option whose underlying instrument is intangible – an equity index.
The market value of an index put and call tends to rise and fall in relation to the underlying index.
The price of an index call will generally increase as the level of its underlying index increases, and its purchaser has unlimited profit potential tied to the strength of these increases. The price of an index put will generally increase as the level of its underlying index decreases, and its purchaser has substantial profit potential tied to the strength of these decreases.
Pricing Factors Generally, the factors that affect the price of an index option are the same as those affecting the price of an equity option: value of the underlying instrument (an index in this case), strike price, volatility, time until expiration, interest rates and dividends paid by the component securities.
Underlying Instrument The underlying instrument of an equity option is a number of shares of a specific stock, usually 100 shares. Cash-settled index options do not relate to a particular number of shares. Rather, the underlying instrument of an index option is usually the value of the underlying index of stocks times a multiplier, which is generally U.S. $100.
Volatility Indexes, by their nature, are less volatile than their individual component stocks. The up and down movements of component stock prices tend to cancel one another out, lessening the volatility of the index as a whole. However, the volatility of an index can be influenced by factors more general than can affect individual equities. These can range from investors’ expectations of changes in inflation, unemployment, interest rates or other economic indicators issued by the government and political or military situations.
Risk As with an equity option, an index option buyer’s risk is limited to the amount of the premium paid for the option. The premium received and kept by the index option writer is the maximum profit a writer can realize from the sale of the option.