A Guide to Trading Index Options

Trading index options is a method of investing in the general movement of the stock market without having to purchase a wide variety of stocks. Instead, investors purchase an option to buy or sell based on the value of a particular stock index at a given time. 

What Is a Stock Index?

A stock market is a common point where shares of stocks listed on that market are bought or sold. For example, companies listed on the New York Stock Exchange have their stock bought and sold by traders who place orders for buyers through the exchange floor in New York. The process is highly automated now but operates in theory as it always has. A buyer lets a trader know, through a broker or electronically, of his desire to buy a certain stock. The trader then identifies another trader attempting to sell that stock. They agree on a price and log the sale.

A stock index is a “basket” of stocks organized around a general financial makeup. As an example, the S&P 500 Stock Index is a basket of 500 large capitalization stocks. The  S&P index tracks the movements of these stocks. The Russell 2000 Index tracks the movement of 2000 small capitalization stocks. The S&P and Russell - and the many other stock indexes, such as the Dow Jones Industrials - are not stocks themselves, but represent the combined value of the stocks that comprise them.

How Can an Index Be Traded?

Brokers sell options or contracts to investors to buy or sell in the future based on the changing value of a given stock index. Typically, what the investor pays at the end of the option period is the current value of the index plus or minus the value of the index at the time the option was purchased times $100.

A Simple Method of Tracking the Market

Trading index options allows an investor to participate in the broad movement of the stock market without having to purchase a wide variety of stocks. The investor makes one investment in the stock index and the index moves up or down with the value of the stocks that comprise it.

Used as a Hedge

It is rare that a non-professional stock trader can pick stocks on his own that will beat the market index. Even professional traders have difficulty doing this. While trading index options reduces the possibility of the “big win” where one given stock jumps in a short period of time, it also reduces the risk of the “big loss.” 

Tax Advantage

It would be very expensive to purchase a position in a broad market by buying individual stocks. The benefit of such a position is that your risk is reduced by having a portfolio of stocks versus all of your money in one company. However, with one investment in index options, you can get that broad exposure across many stocks. And because stock index option trading involves a commodity as opposed to an equity - in other words, you don’t actually own a piece of any company, you own a contract on where the index’s value will be in the future - any profits on your trades have a lower tax rate.

 

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