UNDERSTANDING INDEX OPTIONS
The Options Industry Council(OIC) is an industry cooperativecreated to educate the investing
public and brokers about the benefits and risks of exchange-tradedoptions. Options are a versatile but complex product and that is whyOIC conducts seminars, distributes educational software andbrochures, and maintains a web site focused on options education.
All seminars are taught by experienced options instructors who provide valuable insight on the challenges and successes that indi-vidual investors encounter when trading options. In addition, thecontent in our software, brochures and web site has been created by options industry experts. All OIC-produced information hasbeen reviewed by appropriate compliance and legal staff to ensurethat both the benefits and risks of options are covered.
OIC was formed in 1992. Today, its sponsors include BATSOptions Exchange, BOX Options Exchange, Chicago BoardOptions Exchange, C2 Options Exchange, International SecuritiesExchange, Miami International Securities Exchange, LLC, NASDAQ OMX PHLX , NASDAQ Options Market, NYSEAmex Options, NYSE Arca Options and OCC. These organiza-tions have one goal in mind for the options investing public: to pro-vide a financially sound and efficient marketplace where investorscan hedge investment risk and find new opportunities for profitingfrom market participation. Education is one of many areas thatassist in accomplishing that goal. More and more individuals areunderstanding the versatility that options offer their investmentportfolio, due in large part to the industrys ongoing educational efforts.
Table of Contents
Benefits of Listed Index Options 5
What Is an Index? 7
Equity vs. Index Options 9n Pricing Factorsn Underlying Instrumentn Volatilityn Riskn Cash Settlementn Purchasing Rightsn Option Classesn Strike Pricen In-the-money, At-the-money,
Out-of-the-moneyn Premiumn American vs. European Exercisen AM and PM Settlementn Exercise and Assignmentn Exercise Settlementn Closing Transactions
Basic Strategies 15n Buying Index Callsn Buying Index Puts
Index Options Glossary 21
For More Information 26
This publication discusses exchange-traded optionsissued by The Options Clearing Corporation. Nostatement in this publication is to be construed as arecommendation to purchase or sell a security, or toprovide investment advice. Options involve risk andare not suitable for all investors. Prior to buying orselling an option, a person must receive a copy ofCharacteristics and Risks of Standardized Options.Copies of this document may be obtained from yourbroker, by calling 1-888-OPTIONS, or by visitingwww.OptionsEducation.org.
The purpose of this booklet is to provide an intro-ductory understanding of index options and howthey can be used. Index options may be listed on allU.S. option exchanges. Like trading in stocks,options trading is regulated by the Securities andExchange Commission (SEC).
Options exchanges seek to provide competi-tive, liquid and orderly markets for the purchase andsale of standardized options. All option contractstraded on U.S. securities exchanges are issued, guar-anteed and cleared by OCC. OCC is a registeredclearing corporation with the SEC and plays a criti-cal role in the U.S. capital markets as the exclusiveclearinghouse for exchange-traded options. OCCsconservative financial and procedural safeguards,substantial and readily available financial resources,and its members mutual incentives protect theorganization from settlement losses.
As referred to in this booklet, an index is ameasure of the prices of a group of securities orother interests. Although indexes have been devel-oped to cover a variety of interests such as stocksand other equity securities, debt securities and for-eign currencies, and even to measure the cost of liv-ing, indexes on equity securities (which are calledstock indexes) are among the most familiar. The fol-lowing discussion refers only to stock indexes andstock index options.
Stock indexes are compiled and published byvarious sources, including securities markets. Anindex may be designed to be representative of thestock market of a particular nation as a whole, secu-rities traded in a particular market, a broad marketsector (e.g., industrials) or a particular industry (e.g.,electronics). An index may be based on the prices ofall or only a sample of the securities whose prices itis intended to represent. Indexes may be based onsecurities traded primarily in U.S. markets, securi-
ties traded primarily in a foreign market or a combi-nation of securities whose primary markets are invarious countries.
Readers who intend to trade index optionsshould familiarize themselves with the features ofthe underlying indexes*, including the general meth-ods of calculation. Readers who are attempting tofollow a precise and sophisticated strategy involvingindex options may wish to inform themselves aboutthe exact method for calculating each indexinvolved. Information regarding the method of cal-culation of any index on which options are traded,including information concerning the standardsused in adjusting the index, adding or deleting secu-rities and making similar changes is generally avail-able from the options market where the options are traded.
While this discussion will focus on generalcharacteristics of index options, specific classes ofindex options can have slightly different productspecifications. Before investing, you should deter-mine the specific terms of each product class. Thisand other information on index options or optionproducts not included in this booklet can beobtained by contacting the appropriate exchange orThe Options Industry Council (OIC). In addition,OCC publishes a booklet, Understanding EquityOptions, which covers the basics of exchange-listedequity options and is recommended to investorscontemplating the use of index options. This book-let can also be obtained either by callingI-888-OPTIONS or by visiting OICs web site,www.OptionsEducation.org.
This introductory booklet should be read inconjunction with the basic options disclosure docu-ment, Characteristics and Risks of StandardizedOptions, which outlines the purposes and risks oflisted options transactions. Despite their many ben-efits, options are not suitable for all investors.
Individuals should not enter into optiontransactions until they have read and understood the
*Definitions for italicized words in bold can be found in theglossary section of this booklet.
risk disclosure document which can be obtainedfrom their broker, by calling 1-888-OPTIONS, orby visiting www.OptionsEducation.org. It must benoted that despite the efforts of each exchange toprovide liquid markets, under certain conditions itmay be difficult or impossible to liquidate an optionposition. Please refer to the disclosure document forfurther discussion on this risk and other risks oftrading index options. In addition, margin require-ments, transaction and commission costs and taxramifications of buying or selling options should bediscussed thoroughly with a broker and/or tax advi-sor before engaging in option transactions.Note: For the sake of simplicity, the calculations of profitand loss amounts in this booklet do not account for theimpact of commissions, transaction costs and taxes.
Benefits of Listed Index Options
Like equity options, index options offer the investor anopportunity either to capitalize on an expected marketmove or to protect holdings in the underlying instru-ments. The difference is that the underlying instru-ments are indexes. These indexes can reflect the char-acteristics of either the broad equity market as a wholeor specific industry sectors within the marketplace.
Index options enable investors to gain exposure to themarket as a whole or to specific segments of the mar-ket with one trading decision and frequently with onetransaction. To obtain the same level of diversifica-tion using individual stock issues or individual equityoption classes, numerous decisions and transactionswould be required. Employing index options candefray 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 morethan the price of the option, the premium.
Index options can provide leverage. This means anindex option buyer can pay a relatively small premi-um for market exposure in relation to the contractvalue. An investor can see large percentage gainsfrom relatively small, favorable percentage moves inthe underlying index. If the index does not move asanticipated, the buyer's risk is limited to the premi-um paid. However, because of this leverage a smalladverse move in the market can result in a substan-tial or complete loss of the buyer's premium.Writers of index options can bear substantiallygreater, if not unlimited, risk.
Guaranteed Contract Performance
An option holder is able to look to the system creat-ed by OCC's By-Laws and Rules rather than to anyparticular option writer for performance. Throughthat system, OCC guarantees performance to sell-ing and purchasing clearing members, eliminatingcounterparty credit risk. Prior to the existence ofoption exchanges and OCC, an option holder whowanted to exercise an option depended on the ethi-cal and financial integrity of the writer or his bro-kerage firm for performance. Furthermore, therewas no convenient means of closing out one's posi-tion prior to the expiration of the contract.
OCC, as the common clear