Index Options: Pricing, Volatility & Risk
...Continued from Index Options: Understanding The Underlying
Equity vs. Index Options
An equity index option is an option whose underlying instrument isintangible - an equity index. The market value of an index put and calltends to rise and fall in relation to the underlying index.
The priceof an index call will generally increase as the level of its underlyingindex increases, and its purchaser has unlimited profit potential tiedto the strength of these increases.
The price of an index put will generally increase as the level of itsunderlying index decreases, and its purchaser has substantial profitpotential tied to the strength of these decreases.
Generally, the factors that affect the price of an index option are thesame as those affecting the price of an equity option: value of theunderlying instrument (an index in this case), strike price,volatility, time until expiration, interest rates and dividends paid bythe component securities.
The underlying instrument of an equity option is a number of shares ofa specific stock, usually 100 shares. Cash-settled index options do notrelate to a particular number of shares. Rather, the underlyinginstrument of an index option is usually the value of the underlyingindex of stocks times a multiplier, which is generally U.S. $100.
Indexes, by their nature, are less volatile than their individualcomponent stocks. The up and down movements of component stock pricestend to cancel one another out, lessening the volatility of the indexas a whole.
However, the volatility of an index can be influenced by factors moregeneral than can affect individual equities. These can range frominvestors' expectations of changes in inflation, unemployment, interestrates or other economic indicators issued by the government andpolitical for military situations.
As with an equity option, an index option buyer's risk is limited tothe amount of the premium paid for the option. The premium received andkept by the index option writer is the maximum profit a writer canrealize from the sale of the option.
However, the loss potential fromwriting an uncovered index option is generally unlimited. Any investorconsidering writing index options should recognize that there aresignificant risks involved.
The differences between equity and index options occur primarily in theunderlying instrument and the method of settlement. Generally, when anindex option is exercised by its holder, and when an index optionwriter is assigned, cash changes hands.
Only a representative amount of cash changes hands from the investorwho is assigned on a written contract to the investor who exercises hispurchased contract. This is known as cash settlement.
Continued in "Index Options: The Nuts & Bolts"
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