An Introduction To Index Options
The Benefits of Listed Index Options
Like equity options, index options offer the investor an opportunity toeither capitalize on an expected market move or to protect holdings inthe underlying instruments. The difference is that the underlyinginstruments are indexes.
These indexes can reflect the characteristicsof either the broad equity market as a whole or specific industrysectors within the marketplace.
Index options enable investors to gain exposure to the market as awhole or to specific segments of the market with one trading decisionand frequently with one transaction.
To obtain the same level ofdiversification using individual stock issues or individual equityoption classes, numerous decisions and transactions would be required.Employing index options can defray both the costs and complexities ofdoing so.
Predetermined Risk For Buyer
Unlike other investments where the risks may have no limit, indexoptions offer a known risk to buyers. An index option buyer absolutelycannot lose more than the price of the option, the premium.
Index options can provide leverage. This means an index option buyercan pay a relatively small premium for market exposure in relation tothe contract value. An investor can see large percentage gains fromrelatively small, favorable percentage moves in the underlying index.
If the index does not move as anticipated, the buyer's risk is limitedto the premium paid. However, because of this leverage, a small adversemove in the market can result in a substantial or complete loss of thebuyer'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 created by OCC's Rulesand By-Laws (which includes the brokers and Clearing Members involvedin a particular option transaction) and to certain funds held by OCCrather than to any particular option writer for performance.
Prior to the existence of option exchanges and OCC, an option holderwho wanted to exercise an option depended on the ethical and financialintegrity of the writer or his brokerage firm for performance.Furthermore, there was no convenient means of closing out one'sposition prior to the expiration of the contract.
As the common clearing entity for all U.S. exchange-traded securitiesoption transactions, OCC resolves these difficulties. Once OCC issatisfied that there are matching orders from a buyer and a seller, itsevers the link between the parties. In effect, OCC becomes the buyerto the seller and the seller to the buyer.
As a result, the seller can buy back the same option he has written,closing out the initial transaction and terminating his obligation todeliver cash equal to the exercise amount of the option to OCC. Thiswill in no way affect the right of the original buyer to sell, hold orexercise his option. All premium and settlement payments are made toand paid by OCC.
Continued in "Part One"...
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