Index Option: What is it & It's Types?| Espresso

What Is Index Options & Its Types

An index option is a financial derivative whose value is determined from the primary stock market index. Simply put, an index option is an underlying asset that gives a holder the right to sell or buy the underlying stock options at a predetermined price. Index options consist of call option and put option that confers the holder the right (not the obligation) to buy or sell assets.

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Understanding an Index Option

The call and put options in the index option are two popular tools to trade the regular direction of an underlying asset or index, thereby putting very less capital amount at risk. For index call options, the profit potential is unlimited for the investors. However, the risks involved are also limited to the premiums paid for the covered call option.

For the put option, the risks are limited to the premiums paid. However, the potential profit is capped at the level of the index. So, the lesser the premiums paid, the lower the risks as the index price can never go below zero.

For an investor, an index option can be used for diversifying the investment portfolio if they are not willing to invest directly in the index options of the underlying assets or stocks. For investors, an index option can also be used for hedging a few specified risks in their investment portfolios.

Also Read: What are Stock Market Indices?

Types of Index Options in India

As mentioned above, the index option comprises two tools; the put option and the call option. Let’s get into the details of both these types below.

  • Put Option

The put option in index options is the right of selling the underlying assets at a predetermined price on a specific date or the expiration date. This is because the writer or the seller of the option contract is short on the option. The put option means when the trader has already purchased the option contract to sell.

So, even when the stock price is below the underlying asset value, and if the trader decides on buying the option for selling and buys back the stock, they will be able to make a profit as the buying price would be lower than the selling price.

Put options are also termed as in, at, and out of the money. So, it's called 'in the money' when the underlying asset price is below the put option price. It is called 'out of the money' when the underlying asset price is above the put option price. Finally, when the underlying asset price and the put option price are equivalent, it is called ‘at the money’.

  • Call Option

In the call option, the buyer has the right of purchasing a bond, stock, or commodity at a specified price within a stipulated period. The bond, commodity, or stock is an underlying asset. In the call option, the buyer can profit once the asset price increases. This specified price is fixed and is termed the strike price.

The buyer needs to work out their options before the expiry date of the asset, after which the seller will have no other choice but sell the underlying asset at the fixed strike price. When a trader buys an option at a strike price that is below the underlying stock price and later sells the same, they profit. For instance, if you buy a call option that has a strike price of ₹50, you can exercise your option of buying the stock at ₹50 before its date of expiry.
Know More about Call Put Options

Conclusion

In the Indian stock markets, options expire on the last Thursday of every month. The underlying assets could be anything from bonds, commodities, stocks, stock indices, interest rate futures, and so on. Options are, therefore, named on the underlying assets like futures options, stock options, commodity options, and index options, among others.
Also Read: Indian Stock Market Trading & It's settlement Process

 

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Frequently Asked Questions

A derivative in the share market is a securitised contract whose price depends upon the underlying assets. Its value is determined by the price fluctuations in that particular asset.

An options contract provides the holder with the right of buying or selling an underlying asset at a fixed price, which is also known as the strike price.

A put option gives the right to the investor to sell some amount of the underlying asset at a quantified price on or before the expiration date.

A call option is a contract that provides the option of buying an underlying asset to the buyers at a predetermined price within a stipulated time frame.

Index options are the ones whose underlying assets are stock indices. Traders with index options can invest in the trends of an entire stock market without trading on options on individual stocks or securities.