What are Index Options Trading & How to Invest in Them?

In the derivatives market, options trading allows you to capture a higher leverage. The options contract enables the holder to have the right to buy or sell an underlying asset. When this underlying asset is an index, it is called an index options contract. Let us learn about the index option, its definition, and how to capitalise on the stock indices.

What are Index Options?

In the stock market, the indexes are used to measure the performance of a group of assets, which could be stocks. So, a stock market index refers to a collection of stocks based on specific characteristics. The Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) have different types of indexes that track various market sectors and the overall market. The indexes, such as Nifty Bank, BSE Healthcare, etc, are examples of sector-based indexes. The standard and well-known benchmark indexes are the Nifty 50 and BSE Sensex. Thus, the indexes act as a benchmark to track the best stocks in the market in a specific sector or in general.

When the options contract is created based on the index as the underlying asset, it refers to index options. The buyer or seller is not obligated to exercise the contract by the date of expiry.

In index options trading, investors and traders take specific positions on the index instead of stocks. You can create options contracts on broad indexes such as Nifty 50, depending on your interest. It allows you to take positions based on larger indexes instead of independent stocks. Creating a portfolio of options contracts with contradictory indexes helps you hedge against market movements. This can help you generate profits when the index moves in both directions.

Benefits of Index Options Trading

In the derivatives market, index options trading offers the following advantages:

• Gains from market movements – With index options, you can profit from market movements in both directions. It helps you to make profits during rising and falling markets. 
• Hedging – Index tools enable you to hedge to protect your underlying portfolio from huge losses due to unpredictable market movements. 
• Leverage – Options contracts allow you to capture higher leverage as your investment only corresponds to the option premium. With a small investment, you can control a larger portion of the asset, which will help you generate considerable returns if the market moves favourably. 

How Index Options Trading Works

In India, index options are offered when the futures are already available. A benchmark that reflects the option pricing is necessary. The index options will be made available for trading after the market knows the strike price, lot size, and expiration dates. Like any other options contract, the buyers only make premium payments if they want to opt out of index options contracts before or at the expiry of index options. Thus, the premium payment is the maximum loss a buyer can incur if there is a loss. The seller of the options contract must fulfil the demand once the buyer exercises his right. 

With index option trading, three factors are crucial:

1. Strike price
2. Value of the underlying index
3. The expiration date of the contract

The crucial types of option contracts are:

• Call options – Investors have the right but not the obligation to purchase the underlying index at the known strike price on or before the date of expiry
• Put options – Investors have the right but not the obligation to sell the underlying index at the known strike price on or before the expiry date 

On the date of expiry, any one of the following events happens:

• The contract is settled by both buyer and seller
• Contract expires worthless

For the buyer or seller, the profit is the difference between the strike price and the value of the underlying index on the date of expiration. 

In index options trading, the value is determined based on index movements. It is determined based on: 

• Spot price of the underlying index
• Days to expiry
• Strike price
• Stock price volatility
• Risk-free rate
• Dividend

The value of the index option is not known directly. Multiple mathematical models can be employed to calculate the values of the options. Models such as the Black Scholes, binomial trees, Vanna-Volga pricing, and others are useful for estimating the fair pricing of options. This depends on the varying market conditions and existing variables in the market. 

What are Index Options Strategies?

Different strategies are used in index options trading. The way the call or put options are placed differs with these strategies. Some of the well-known index options strategies are:

• Bull call spread – A call option is purchased at a lower strike price, while a call option is shorted at a higher strike price. This approach reduces the overall cost when the higher strike is sold far out of the money. Thereby, it also limits the profit potential when the index rises. However, it also reduces initial investment and ensures capital protection. 
• Bear put spread – Here, a put option is purchased at a higher strike price, and a put option is shorted at a lower strike price. This method is suitable when you expect the underlying index price to fall. The expiration date should be identical with both options. The strategy allows you to make profits when the index prices go down. 
• Hedging – Many investors use hedging portfolios to purchase index put options. 
• Sell covered call options – Here, you purchase the index options and sell the call options against them. Through this method, investors can profit from increasing index prices. When the index goes above the strike price, the options contracts can be sold at the strike price to realise profits. 

Conclusion

Index options in India are a popular investment avenue among those with knowledge of the derivatives market. You can find an index options list on the BSE and NSE websites to make gains based on market fluctuations. The leverage in index options contracts can increase the potential for both profits and losses. A thorough understanding of the market and trading strategies is crucial to generating positive revenue from the derivatives market.