Fundamentals of Index Options

Types of Stock Indexes

Download: Fundamentals of Index Options

There are numerous underlying stock indexes on which options may be based. To set your profit expectations it helps to understand what the
index is actually tracking. In this class you will learn:

What a stock index is

The difference between broad-based and sector indexes
Stock indexes can track stocks within a limited range of market capitalization

What is a Stock Index?

A stock index is a statistic, or an indicator that can be used to measure and report the changing value of a group of stocks, referred to as its
components. The index represents the market prices of each individual component stock compiled, through one of several methods, into a single
number. Of primary use to investors, an index is a tool to monitor the ups and downs of the stock marketplace, within any given trading day or
relative to any time in the past (or future).

Whenever you ask “How’s the market doing?” the answer to your question will always reflect the performance of the market as measured by a
changing index level. Seeing that an index level might currently be 1000.00 in itself doesn’t tell you that much. Knowing that the index level has
risen or fallen 10% over the last year tells you a lot more.

There are a variety of stock indexes widely followed by investors. To name just a few:
SM
Dow Jones Industrial Average
®
S&P 500
®
Nasdaq-100
®
Russell 2000

How any specific stock index tracks its underlying market depends on both its composition (the set of stocks) and the method used to calculate
that index.

Index Types

Stock indexes generally fall within two types: broad-based indexes and sector indexes. These terms do not suggest the number of component
stocks used to calculate an index, but instead the diversity of the stocks and the market it tracks. Indexes may be further categorized as small-,
mid- or large-cap, which reflect the total market capitalization range of their component stocks.
Broad-Based Indexes

Broad-based indexes measure moves in the entire stock markets they track, and their component stocks generally represent publicly traded
companies from across a widely diversified range of major industry groups. These indexes are commonly viewed to reflect changing investor
sentiment on the state of the economy as a whole.

Broad-based indexes would include:

Dow Jones Industrial Average (30 stocks)

S&P 500 (500 stocks)
S&P 100 (100 stocks)
Nasdaq-100 (100 stocks)
Russell 2000 (2000 stocks)

Sector Indexes

Sector indexes generally focus on tracking moves in specific industry groups within the broad marketplace, such as transportation, utilities,
technology, oil, and gold. These indexes reflect changing investor sentiment on the specific industries they track.

Sector indexes would include:

Dow Jones Transportation Average

Dow Jones Utility Average
CBOE Technology Index
CBOE Oil Index
CBOE Gold Index

Market Capitalization

Stock indexes might also be categorized according to the market capitalizations of each of their component stocks: large-cap, mid-cap and
small-cap (even micro-cap). The parameters that qualify stocks as being in one of these capitalization (“cap”) groups are not fixed, and may vary
among the institutions that calculate such indexes. Within these categories, however, the component stocks might represent diversified industry
groups.

A company’s total market capitalization is generally calculated by taking the total number of outstanding shares and multiplying by the shares’
current market price.

Approximate Range of
Company’s Classification
Total Market Capitalization
Large-cap
over $10 billion
(large capitalization)
 Mid-cap
between $2 billion and $10 billion
(middle capitalization)
Small-cap
between $300 million and $2 billion
(small capitalization)
Micro-cap
between $50 million and $300 million
(micro capitalization)

Understand Your Investment

Before you buy an index option it’s important to understand what the underlying index is tracking. The performance of companies in an industry
sector, as well as each category of market capitalization range, might vary seasonally or relative to different economic environments.

Stock Index Calculation

There are numerous methods used to compute an index value, even for those indexes that might track the performance of the same group of
stocks. The difference in these methods lies mainly in the way in which price changes of each stock can affect the index’s level, or how the index
is weighted. In this class you will learn about:

Capitalization-weighted indexes
Price-weighted indexes

Index Weighting

Stock indexes come in various shapes and sizes. They can track and measure broad market moves, or the performance of a group of stocks
from a specific industry within the broad market. But beyond the markets or industries they can be based on, indexes can be calculated in
different ways. Even when some indexes might be based on identical sets of stocks, their measurement of the performance of these stocks may
vary because of different methods used to calculate them.

In a manner of speaking, many stock indexes may be considered averages, but in general they are not simple averages. Instead they are
weighted averages, and there are different methods used to weight the contribution an index’s component stocks may make to the overall index
level. The end result is that from one index to another the price change of a component stock can affect the overall value of the index in different
ways, or to different degrees.

There are numerous methods for weighting indexes, but we will consider the two kinds of indexes most widely followed by investors:

Capitalization-weighted
Price-weighted
Capitalization-Weighted Indexes

With a capitalization-weighted stock index, also know as value-weighted, each component stock is weighted in proportion to its total market
capitalization (“cap”) amount: total number of shares outstanding x the current price per share. In other words, a component stock’s impact on
the overall index calculation is in proportion to the size of the company issuing those shares, not the price of its shares. A given price change in a
share of a company with a larger market cap will affect the index level to a greater degree, or have more “weight” in the index, than the same
change in share price of a company with a smaller market cap.

As an example, in the table below see a hypothetical stock index named XYZ that is comprised of only two stocks. The total market cap of the
two stocks is $120 million, so in proportion to their market caps each stock is assigned a weighting (in percent). Say each stock increases $10.
We’ll see how the same dollar increase in these stocks might affect the overall value of the index.

XYZ Index
Component Market Weight in Change in Effect on
Stock Capitalization Index Stock Price Index Level
Stock A $90 million 75% + $10 + 7.5 points
Stock B $30 million 25% + $10 + 2.5 points

For a $10 increase in Stock A’s price (higher market cap) the index level might increase by 7.5 points. For a $10 increase in Stock B’s price
(lower market cap) the index level might increase by only 2.5 points. A majority of widely followed indexes are capitalization-weighted (or a
variation of this method). Examples are the S&P 500 ® , the Nasdaq-100 ® and the Russell 2000 ® .

Price-Weighted Indexes

With a price-weighted stock index, the component stocks are weighted by their current market price. In other words, a component stock’s impact
on the overall index calculation is in proportion to the price of its shares, not the size of the company issuing those shares. The result is that a
given change in share value of a higher-priced stock will affect the index level to a greater degree, or have more “weight” in the index, than the
same change in the share value of a lower-priced stock.

As an example, take a hypothetical stock index named XYZ that is comprised of only two stocks. From the current price, say each stock
increases 10%. We’ll see how the same percentage increase in these stocks might affect the overall value of the index.

XYZ Index
Component Current Price Change in Effect on
Stock Price Up 10% Stock Price Index Level
Stock A $100 $110 + $10 + 5 points
Stock B $10 $11 + $1 + 0.5 points
For a 10% increase in Stock A’s price (the higher-priced stock) the index level might increase by 5 points. For a 10% increase in Stock B’s price
(the lower-priced stock) the index level might increase by only 0.5 (½) point. An example of this type of index is the Dow Jones Industrial
SM.
Average

Final Word

The brief discussions of index calculation methods in this tutorial are by no means comprehensive. Their purpose is simply to provide you an
overview of the different methods of weighting that might be used to calculate an index, especially as they relate to the effect changing
component stock prices can have on index levels.

For more information about the methodology used for a particular index you might check the website of the organization (e.g., Dow Jones,
Standard & Poor’s, etc) that created it.

Index Option Pricing Factors

Just as with equity options, there are six primary factors that affect the prices of index options. They are the same factors used in most option
pricing models, but for a few of the factors we’ll take a closer look. In this class you will learn about:

The six factors that affect an index option’s price

Dividends as they relate to index options
Volatility of indexes
Time value of European-style vs. American-style options
Greeks for index options

Six Factors that Affect an Index Option’s Price

There are six measurable factors that affect an index option’s price, and these factors are used as input for most widely used option pricing
models. They are:

Value of underlying index

Strike price
Volatility
Time until expiration
Dividends
Interest rates
These are the same factors that affect the prices of equity options, and for each individual factor an increase or decrease will affect index option
prices in a similar way. Let’s take a look at each factor and consider any differences as it relates to underlying indexes and index options.

Index ↓ Index ↑
Value of Underlying Index
Call ↓ Put ↑ Call ↑ Put ↓

The underlying instrument for an equity option is a stock traded on one or more U.S. stock exchanges. As the underlying stock trades during any
business day, or over time, the price will change. For an index option, the underlying instrument is an index, an abstract number, and the level of
this index also changes. It is recalculated every few seconds and disseminated throughout each trading day. For the reason you monitor an
underlying stock’s price when you have an equity option position, so would you monitor the underlying index level when you have a position in an
index option.

As the level of an underlying index increases, the prices of calls based on the index generally increase, and puts decrease. As the index level
decreases, the prices of calls generally decrease, but puts will increase.

When you buy an index option you want that option to increase in value as the underlying index level changes in your favor, just as you want an
equity option to increase in value when the underlying stock moves as you expect.

Strike Price ↓ Strike Price ↑

Strike Price
Call ↑ Put ↓ Call ↓ Put ↑

Each index call and put has a strike price that will determine whether that option is in-the-money, at-the-money or out-of-the-money. For an
equity option this strike price represents the price per share that you either buy or sell the underlying stock after exercise or assignment.

For an index option, you don’t buy or sell the component stocks that make up the index. The strike price, and its relation to the underlying index
level, ultimately determines the amount of cash that you will receive if you exercise a long in-the-money index call or put. Likewise this relation will
determine the amount of cash you will pay when assigned on a short index call or put. It is an option’s in-the-money amount, or its intrinsic value,
that changes hands after it’s exercised, not shares of stock.

Volatility ↓ Volatility ↑
Volatility
Call ↓ Put ↓ Call ↑ Put ↑

The volatility, or degree of fluctuation in an underlying stock’s price, has an effect of the price of an equity option. A stock’s price fluctuation in the
past can be observed and measured; this is called the stock’s historical volatility. Index levels fluctuate just as stock prices do. This fluctuation
can be observed and measured, and is referred to as the index’s historical volatility. You might use this number in an index option pricing
calculator.

When comparing the volatility levels of indexes to those of individual stocks you’ll observe that overall index volatility is generally lower than those
for many of its components. This is due to the effect of an index’s diversification in terms of how many stocks make up the index. Over time, the
price movements of some component stocks will offset price changes of others.

For example, let’s say a hypothetical index is made up of stocks that each has a volatility of 30%. The volatility of the whole index would most
likely be less than 30%.

Also like equity options, individual options on the same underlying index (or option series) have implied volatility amounts that you might determine
with an option calculator. These implied volatilities may differ from the index’s historical volatility. It is also not at all unusual for the implied
volatility levels of different options on the same index to vary, even more than they might for equity options on the same stock. This phenomenon
is referred to as “volatility skew.”

Index Option Pricing Factors - Continued

Days until Days until

Expiration ↓ Expiration ↑
Time until Expiration
Call ↓ Put ↓ Call ↑ Put ↑
Index option premiums are made up of both intrinsic value (if any) and time value. And just like other options the time value component of these
premiums experience time decay. At expiration, an index option is worth its exercise settlement amount, or its intrinsic value, if it is in-the-money
and has any. The rate of time decay can be estimated in advance with an index option pricing calculator.

The relative amounts of time value in American-style index options are generally greater than in European-style contracts. Remember,
American-style options may be exercised at any time before expiration, European-style only at expiration.

For the ability to exercise early, American-style options are generally priced higher than similar contracts (considering strike price and index level
relationship) that are European-style. As an example, consider a hypothetical index XYZ that might underlie options of both exercise style. At a
given moment an American-style 500 call might trade for $6.00, while the European 500 call might trade for $5.75.

Dividend ↑ Dividend ↓
Dividends
Call ↓ Put ↑ Call ↑ Put ↓
If a particular stock issue pays a regular dividend, it will do so at discrete intervals, possibly quarterly. These dates are known and considered in
an equity option’s price. For an index, composed of many component stocks and possibly many dividends, it’s not so convenient to consider when
each dividend might be paid, and each stock’s price reduced accordingly.

When calculating values for index options, it’s common for investors to consider an index’s dividend yield, which assumes a total dividend flow
that is continuous and even throughout the option’s lifetime. Market professionals, on the other hand, might consider any dividends paid by
component stocks on a daily basis. This can lead to discrepancies between theoretical values and index option values found in the marketplace.

Interest Rate ↑ Interest Rate ↓

Interest Rates
Changing interest rate can affect index option prices just as it does prices of equity options. When pricing an equity option, the interest rate
component considers the cost of a position in an equivalent number of underlying shares. For instance, call buyers would consider in the cost of
the option the interest they might pay for owning 100 underlying shares. This interest might be paid to a brokerage firm when buying shares on
margin, or given up when the cash required to buy the shares could otherwise be earning interest.

For an index call option, this interest would be incurred, or given up, for owning a portfolio containing shares in each of the index’s component
stocks. For one index call, the amount of this interest would be considerably greater for an entire portfolio than for an equity call’s equivalent 100
underlying shares. This would in part explain why you might see index options as “more expensive” than equity contracts.

Special Considerations

Certain trading strategies involve purchases and sales of index options, index futures, options on index futures or portfolios of certain securities in
an index. These can affect the value of the index, the prices of the index futures and, therefore, the prices of index options. These transactions
and the resulting impact may occur at any time – and may accompany significant changes in the prices or volatilities of the stock and derivative
markets – including at or shortly before expiration.

For example, traders holding positions in expiring index options or futures contracts hedged by positions in securities included in the index may
attempt to liquidate their securities positions at or near the time for determining the final exercise settlement value of the options or futures
contracts. The resulting orders to liquidate these securities might result in significant changes in the level of the index.

Index option investors should be aware of the potential impact that these trading strategies can have on index levels, especially at or near
expiration, and the possibility that the values of index option positions will be affected accordingly.

Cash Settlement

When an equity option is exercised, shares of underlying stock change hands. With index options, however, only cash is exchanged between the
person exercising an option and the person assigned. In this tutorial you will learn about:

The cash settlement feature of index options

How to calculate the cash amount that changes hands after an index option is exercised

Cash Settlement

Equity options are considered “physical delivery” contracts. This simply means that for each call or put exercised, shares of underlying stock
(generally 100) will change hands between the owner of a long contract who exercises it and the writer of a similar contract who is subsequently
assigned an exercise notice.

For index options the underlying instrument is not a single stock issue, but instead an index comprised of many different stocks, which sometimes
number in the 1000’s. Since transfer of a number of shares of each stock after exercise would be a cumbersome process, index options are
cash-settled. In other words, a specific amount of cash, instead of underlying shares, will change hands.

Who gets this cash? Whether the index option is a call or put, only the owner of a long contract has the right to exercise (like equity options).
After doing so, the writer of a similar contract will be assigned and required to pay a cash amount to the contract owner who exercises.

Contract Multiplier

Index levels are abstract numbers and are measured in points, not necessarily dollars. The premiums of index options are also technically quoted
in points, with each point representing $100. In other words, the multiplier for index option contracts is $100. For example, you buy an index call
for a quoted price of 6.50. The amount you’ll pay for this contract is:

6.50 x $100 multiplier = $650 total premium

This is similar to equity options. Since their premiums are quoted per underlying share (100), the total premium you’d pay or receive is 100 times
the transaction price.

Even though index option premiums are technically quoted in points, it is common to see them indicated as dollar amounts. That is you might see
a premium cited as either 6.50 or $6.50.

In-the-Money, At-the-Money, Out-of-the-Money

Like equity options, index options have the same qualities of being in-, at- or out-of-the-money, which are determined in a similar manner. The
difference is only that for an index option the underlying is an index level not a stock price. Index options also have strike prices.

Index calls are:

in-the-money when the strike price is less than the underlying index
at-the-money when the strike price and underlying index level are the same
out-of-the-money when the strike price is greater than the underlying index

Index puts are:

in-the-money when the strike price is greater than the underlying index
at-the-money when the strike price and underlying index level are the same
out-of-the-money when the strike price is less than the underlying index

These concepts become important when determining the amount of cash that changes hands when an index option is exercised.

Cash Settlement Amounts

When an index option is exercised, the “cash settlement amount” changes hands. This amount is the difference between the option’s strike price
and the underlying index level – its in-the-money amount, or intrinsic value. But when it comes to exercise and assignment, what index level is
used? This is called the index’s “settlement value,” which is determined in one of two ways depending on whether the option contract is
American-style or European-style.

American-style index options, which can be exercised any time before they expire, have “PM settlement.” That is, the index settlement value is
the closing value of the index on the day the option is exercised. At expiration it is the closing value on Friday before expiration day (Saturday).

European-style index options can be exercised only at expiration, and have “AM settlement.” They generally stop trading on the last Thursday
before expiration, but the index settlement value is calculated from the opening prices of the index’s component stocks on the following morning,
or Friday before expiration.

Cash Settlement - Continued

Exercising an Index Call

Let’s take a look at cash settlement after exercising an index call option. Say you bought an XYZ Index 500 call for $6.00, or $600 total
(excluding commission). With an index settlement value of 520 you exercise this in-the-money call in order to receive cash payment. How much
cash will you be paid?

520 settlement value – 500 strike price = 20 x $100 multiplier = $2,000 settlement amount

You’d receive a total cash payment amount of $2,000 (less exercise fee), which the call’s in-the-money amount (intrinsic value). But this is, of
course, not all profit. You must subtract the premium you initially paid for the call.

$2,000 settlement amount received – $600 premium paid = $1,400 total profit

The person assigned an exercise notice would pay you this cash.

Assignment on an Index Call

As for assignment on a written, short index call contract the cash settlement process works in reverse to exercise. Say you initially sold an XYZ
Index 500 call for $6.00, or $600 total (excluding commission). With an index settlement value of 520 you are assigned on this in-the-money call
and are obligated to pay the cash settlement amount. How much cash will you have to pay?

520 settlement value – 500 strike price = 20 x $100 multiplier = $2,000 settlement amount

You’d pay a total cash payment amount of $2,000 (plus exercise fee), which the call’s in-the-money amount (intrinsic value). But are you realizing
a profit or a loss? Since you are paying out more cash on assignment than you initially received from writing the call, you are seeing a loss.

$2,000 settlement amount paid – $600 premium initially received = $1,400 total loss
You are paying this cash to the person exercising the call contract.

Exercising an Index Put

Let’s now take a look at cash settlement after exercising an index put option. Say you bought an XYZ Index 800 put for $5.00, or $500 total
(excluding commission). With an index settlement value of 785 you exercise this in-the-money put in order to receive cash payment. How much
cash will you be paid?

800 strike price – 785 settlement value = 15 x $100 multiplier = $1,500 settlement amount

You’d receive a total cash payment amount of $1,500 (less exercise fee), which the put’s in-the-money amount (intrinsic value). But this is not all
profit. You must subtract the premium you initially paid for the put.

$1,500 settlement amount received – $500 premium paid = $1,000 total profit

The person assigned an exercise notice would pay you this cash.

Assignment on an Index Put

As for assignment on a written, short index put contract the cash settlement process works in reverse to exercise. Say you initially sold an XYZ
Index 800 put for $5.00, or $500 total (excluding commission). With an index settlement value of 785 you are assigned on this in-the-money put
and are obligated to pay the cash settlement amount. How much cash will you have to pay?

800 strike price – 785 settlement value = 15 x $100 multiplier = $1,500 settlement amount

You’d pay a total cash payment amount of $1,500 (plus exercise fee), which the put’s in-the-money amount (intrinsic value). But are you realizing
a profit or a loss? Since you are paying out more cash on assignment than you initially received from writing the put, you are seeing a loss.

$1,500 settlement amount paid – $500 premium initially received = $1,000 total loss

You are paying this cash to the person exercising the put contract.