How index options are different from stock options? Advantages and Disadvantages of trading Index Options.

To begin with understanding how index options are different from stock options, it is most important to make a clear point of understanding between the two from their meaning to functionalities and features to have in-depth knowledge and visualization.

Starting with Index Option:

What are Index Options

Index options are a widely used derivative product listed on Indian stock markets, mainly the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). Similar to options on individual shares, index options find their value from a stock market index, for example, the Nifty 50 or the Bank Nifty. They provide investors and traders with an opportunity to bet on the direction of the overall market or the movement of a particular sector without having to purchase or sell the component stocks of the index.   In other words, an index option is a contract that entitles the buyer to the right, but not the obligation, to buy or sell the underlying index at a predetermined price called the strike price on a specified date known as the expiration date. The seller of the option is bound to fulfil the contract if the buyer exercises it.

 

Types of Index Options Available in India:

Index options trading involves numerous strategies, each designed to fit particular market conditions and risk levels.

• Covered Calls: Covered calls are the sale of a call option accompanied by owning the underlying index shares. It can produce income while capping potential losses.

•Protective Puts: Protective puts are purchasing a put option in order to protect against the decrease in the underlying index shares' value. The strategy insures against loss but caps gains.

•Straddles and Strangles: Straddles involve buying both a call and a put option at the same strike price, whereas strangles consist of buying a call and a put option of different strike prices. The strategies are employed to gain from large price movements in either direction.

 

How do Index Option works:

The operation of index options is based on the idea of a premium, a strike price, and an expiration date.

1. Underlying Asset: The underlying asset for an index option is a stock market index, such as the Nifty 50 or Bank Nifty. The option contract's value is based on the movement of this index.

2. Call Options Vs. Put Options:

·       Call Option: Provides the buyer with the option to purchase the underlying index at the strike price. Call option buyers tend to be bullish, hoping that the index will go up above the strike price before expiration.

·       Put Option: This allows the buyer the right to sell the underlying index at the strike price. Typically, buyers of put options are bearish and believe that the index will go down below the strike price before it expires.

3.Strike Price: This is the fixed price at which the buyer of the option can buy for a call or sell for a put the underlying index.

4. Premium: This is what the buyer pays to the seller for the option contract. This is the largest loss to the option buyer. The premium is determined by many factors such as the prevailing level of the index, strike price, time remaining until expiry, volatility of the index, and interest rates.

5.Date of Expiry: This is the date upon which the option contract expires. Index options in India have standard monthly and weekly expiry cycles. Monthly options have expiry on the last Thursday of the month and weekly options expire each Thursday.

6.Lot Size: Index options trade in standard lot sizes, reflecting a particular amount of units of the underlying index.

7. Cash Settlement: Indian index options are usually cash-settled. This implies that at exercise or expiration, there is no delivery of the underlying index (which is not feasible since it's a notional value). Rather, the gain or loss is paid in cash depending on the difference between the strike price and the closing value of the index on the expiration date.

 

Key Characteristics and Benefits:

In the derivatives market, index options trading has the following benefits:

•Hedging: Index instruments allow you to hedge to shield your underlying portfolio against massive losses due to unforeseen market fluctuations.

•Leverage: You can enjoy higher leverage through options contracts because your investment is only equal to the premium for the option. You can control more of the asset with a low amount of investment, and as a result, you'll be able to earn significant returns if the market goes in your direction.

•Profit from market movements: With index options, you are able to earn profits from market movement in both directions. It assists you in gaining profits in both up and down markets.

 

Now proceed to the idea of stock options.

What are stock options:

A stock option is an agreement that grants the owner the right to purchase (call option) or sell (put option) a given number of shares of a single company's stock at a fixed price (strike price) on or before a certain date (expiration date).

The worth of a stock option is actually dependent on the price movement of the underlying single stock. For instance, a Reliance Industries stock option will mirror the movement of Reliance shares. The price of a stock option depends directly on the performance of the particular company's stock. Company-specific news, earnings announcements, management changes, and industry trends all directly and frequently have a major influence on the price of a stock option.

How Stock Option Works:

1. Underlying Asset: The underlying asset is a single equity share of a listed company approved for derivatives trading by the market regulator (SECI) and the exchanges.

2. Exercise Style (American Style): Contrary to European style index options that can only be exercised at expiry, stock options in the Indian market are typically American style. This is to say the option holder is free to exercise his right to buy (in the case of a call) or sell (in the case of a put) the underlying shares at the strike price any time from the date of purchase until the expiry date.

3.Strike Price: The price at which the underlying shares may be purchased or sold.

4.Premium: The option buyer pays to the option seller. It depends on factors such as the stock price, strike price, time to expiry, volatility of the stock, and interest rates.

5. Expiration Date: The last date until which the option can be exercised. Stock options in India are available in fixed terms of their expiry cycle, such as monthly.

6. Lot Size: Stock options are traded in standard lot sizes representing a fixed number of shares in the underlying company.

7. Physical Settlement (in certain cases) or Cash Settlement: Whereas index options are always cash-settled, stock options may lead to physical delivery of shares upon exercise. Nevertheless, cash settlement may also take place in accordance with exchange rules and certain situations, particularly in positions carried to expiry and leading to in-the-money options.

 

Key Characteristics and Benefits:

• American Exercise Style: Indian stock options generally conform to the American exercise style, where an option holder is able to exercise the option (to buy or sell shares at the strike price) at any time up to and including the expiry date, as opposed to European-style options which can be exercised only on the expiry date.

• Standardized Contracts: For orderly trading, stock option contracts are standardized on exchanges. These are fixed Lot Sizes (a fixed number of shares per contract), pre-specified Strike Prices at regular intervals, and specified Expiration Dates, typically in monthly cycles (Near, Mid, and Far months).

•Settlement Mechanism: Although early exercise of American-style stock options may entail physical delivery of the underlying shares, options that are carried to expiry are typically cash-settled. For in-the-money options at expiry, settlement is the cash difference between the final settlement price (typically the closing stock price) and the strike price.

•Premium: The premium is the price paid by the option buyer to the seller. It is a very important part since it is the highest possible loss for the option buyer. The value of the premium fluctuates continuously depending on a number of market factors.

 

Key Difference between Index Option and Stock Option.

1.Underlying Asset:

•Stock Options: Based on individual company stocks; exposed to company-specific risks.

•Index Options: Based on a basket of stocks (e.g., Nifty); represent broader market trends and systemic risks.

2.Settlement Method:

•Stock Options: Physically settled — shares delivered on exercise.

•Index Options: Cash settled — no delivery, only the difference paid in cash.

3.Exercise Style:

•Stock Options: Typically, American-style — exercisable any time prior to expiry.

•Index Options: Typically, European-style — exercisable only on the expiry date.

4.Contract Size and Lot Size:

• Stock Options: Size of a lot varies by stock, as specified by the exchange.

• Index Options: Standard lot size (e.g., Nifty = 50 units); better for analysis and trading.

5.Volatility:

• Stock Options: Greater due to events specific to the company.

• Index Options: Lower due to diversification; less affected by individual-stock price movements.

6.Liquidity:

• Stock Options: Varied; could be lower for illiquid stocks.

• Index Options: Typically more liquid with tighter bid-ask spreads (e.g., Nifty, Bank Nifty).

7.Pricing Complexity:

•Stock Options: Price directly related to the performance of an individual stock.

•Index Options: Price is indicative of the overall performance of the index constituents; more sophisticated but still modelled using conventional pricing instruments.

 

Proceeding to Advantages and Disadvantaged of trading Index Options:

Advantages of Trading Index Options:

•Diversification: Exposure to a portfolio of high-performing stocks in one instrument, minimizing risk related to individual stocks.

•Hedging Against Portfolio Risk: Enables investors to insulate their stock portfolios against market declines through the use of put options or hedge against price increases through call options.

•Lower Volatility Compared to Individual Stock Options (Typically): Diversification of the index levels out price fluctuations of specific companies, resulting in typically lower volatility than individual stock options.

•Leverage: Provides the ability to manage a significant notional value of the underlying index with a relatively low capital investment (premium).

•Limited Risk for Option Buyers: The buyer's maximum potential loss is limited to the premium paid.

•Opportunities in Different Market Conditions: Index options allow traders to benefit from both increasing markets (utilizing call options) and decreasing markets (utilizing put options), providing flexibility in different market directions.

•Liquidity and Tighter Spreads: Major index options in India are highly liquid, allowing for easy entry and exit from positions and generally result in competitive pricing with tighter bid-ask spreads.

• Cash Settlement: Indian index options are settled in cash, making the trade process easier through the elimination of physical delivery of assets and directly settling profits/losses to the trading account on the difference between the settlement index value and the strike price.

 

Drawbacks of trading Index Options:

• Complexity: Understands concepts like intrinsic value, time value, implied volatility, and option Greeks for successful trade.

•Time Decay (Theta): The options lose value as the expiration date nears, which is a negative for option buyers.

•Risk of Huge Losses for Option Sellers: Sellers, especially of uncovered options, can potentially face unlimited risk if the index moves considerably against their position.

•Effect of Implied Volatility (Vega): Option prices are volatile to shifts in market expectations of future volatility, which can greatly impact profitability of trade.

•Need for Constant Monitoring: Positions may require continuous monitoring, especially in volatile markets or around key events, demanding time commitment.

•Gap Risk: Significant news outside trading hours can cause index price gaps, negatively impacting overnight option positions.

• Not Appropriate for Long-Term Investment (for buying options): Buying index options is not generally suitable for very long-term investment due to the effect of time decay (Theta), and they are more appropriate for short to medium-term trading or hedging purposes.

• Brokerage and Trading Charges: Index option trading implies different costs such as brokerage commissions, exchange fees, STT, and other impositions, which tend to get added up and affect the profitability of high-frequency trading.

 

Conclusion:

•Stock options and index options are different financial instruments with different underlying assets, settlement procedures, and risk profiles. Stock options provide focused exposure to specific companies, whereas index options offer diversified exposure to a market or sector. In the Indian context, index options, especially on Nifty and Bank Nifty, are well-liked because of their diversification advantages, hedging, leverage, and cash settlement.

• Nevertheless, index option trading is not without its pitfalls. The built-in complexity of options, the effects of time decay and implied volatility, and the possibility of heavy losses (particularly for sellers) require a complete understanding of the product and prudent risk management strategies.