Index Options - Part Two

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...Continued from Part One

Equity vs. Index Options
An equity index option is an option whose underlying instrument is intangible - an equity index. The market value of an index put and call tends to rise and fall in relation to the underlying index. The price of an index call will generally increase as the level of its underlying index increases, and its purchaser has unlimited profit potential tied to the strength of these increases.

The price of an index put will generally increase as the level of its underlying index decreases, and its purchaser has substantial profit potential tied to the strength of these decreases.

Pricing Factors
Generally, the factors that affect the price of an index option are the same as those affecting the price of an equity option: value of the underlying instrument (an index in this case), strike price, volatility, time until expiration, interest rates and dividends paid by the component securities.

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Underlying Instrument
The underlying instrument of an equity option is a number of shares of a specific stock, usually 100 shares. Cash-settled index options do not relate to a particular number of shares. Rather, the underlying instrument of an index option is usually the value of the underlying index of stocks times a multiplier, which is generally U.S. $100.

Volatility
Indexes, by their nature, are less volatile than their individual component stocks. The up and down movements of component stock prices tend to cancel one another out, lessening the volatility of the index as a whole.

However, the volatility of an index can be influenced by factors more general than can affect individual equities. These can range from investors' expectations of changes in inflation, unemployment, interest rates or other economic indicators issued by the government and political for military situations.

Risk
As with an equity option, an index option buyer's risk is limited to the amount of the premium paid for the option. The premium received and kept by the index option writer is the maximum profit a writer can realize from the sale of the option. However, the loss potential from writing an uncovered index option is generally unlimited. Any investor considering writing index options should recognize that there are significant risks involved.

Cash Settlement
The differences between equity and index options occur primarily in the underlying instrument and the method of settlement. Generally, when an index option is exercised by its holder, and when an index option writer is assigned, cash changes hands.

Only a representative amount of cash changes hands from the investor who is assigned on a written contract to the investor who exercises his purchased contract. This is known as cash settlement.

To Be Continued in Part 3...
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