Index Options - Part 1
Read Part 1 of our information to learn more about what you need to know before trading index options.
Benefits of Listed Index Options
Like equity options, index options offer the investor an opportunity to either capitalize on an expected market move or to protect holdings in the underlying instruments. The difference is that the underlying instruments are indexes. These indexes can reflect the characteristics of either the broad equity market as a whole or specific industry sectors within the marketplace.
Index options enable investors to gain exposure to the market as a whole or to specific segments of the market with one trading decision and frequently with one transaction. To obtain the same level of investment diversification using individual stock issues or individual equity option classes, numerous decisions and transactions would be required. Employing index options can defray both the costs and complexities of doing so.
Predetermined Risk for Buyer
Unlike other investments, where the risks may have no limit, index options offer a known risk to buyers. An index option buyer absolutely cannot lose more than the price of the option, the premium.
Index options can provide leverage. This means an index option buyer can pay a relatively small premium for market exposure in relation to the contract value. An investor can see large percentage gains from relatively small, favorable percentage moves in the underlying index. If the index does not move as anticipated, the buyer's risk is limited to the premium paid. However, because of this leverage, a small adverse move in the market can result in a substantial or complete loss of the buyer's premium. Writers of index options can bear substantially greater, if not unlimited, risks.
Guaranteed Contract Performance
An option holder is able to look to the system created by OCC's Rules and By-Laws (which includes the brokers and clearing members involved in a particular option transaction) and to certain funds held by OCC rather than to any particular option writer for performance. Prior to the existence of option exchanges and OCC, an option holder who wanted to exercise an option depended on the ethical and financial integrity of the writer or his brokerage firm for performance. Furthermore, there was no convenient means of closing out one's position prior to the expiration of the contract.
As the common clearing entity for all U.S. exchange-traded securities option transactions, OCC resolves these difficulties. Once OCC is satisfied that there are matching orders from a buyer and a seller, it severs the link between the parties. In effect, OCC becomes the buyer to 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 to deliver cash equal to the exercise amount of the option to OCC. This will in no way affect the right of the original buyer to sell, hold, or exercise his option. All premium and settlement payments are made to and paid by OCC.
We hope you have found the first part of our guide to how to trade options helpful. Continue with Part 2 here. Start trading options at Firstrade today!
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