To start with an explanation of how index options work, it is very important to know and understand its meaning. Index options – are options whose underlying asset is an index instead of multiple assets or stocks. Their main aim is to let a trader purchase or sell underlying assets at a certain fixed price. Prices can either increase or decrease depending on the following points, such as expiration date, volatility, strike price, dividends and many others. As a rule, index options are tied to such prices as Russell 3000 index which is the Russell Investment Group that is trying to capture the entire US stock market. The number 3000 defines its index – 3000 of the most liquid and largest stocks based and traded in the U.S.
It should be mentioned that index options divide into narrow and broad-based. Broad-based index options track a large number of stocks, whereas narrow-based indexes track only a particular industry.
Unlike index options where an underlying asset is an index, an underlying asset of stock options is stock respectively. Both have call and put options allowing its holders to speculate in the movement of underlying assets. Call Options give its holder a complete right to purchase shares for a particular price and within a certain period of time that is called expiration date. Whereas Put Options allow its holder to sell shares of a stock for a particular price by an expiration date.
Distinctions between Index and Stock Options
Comparing index options with stock options, one can name 5 main distinctions:
- Index options work with different and multiple stocks, unlike stock options that are concentrated on only one company’s stock.
- Index options unlike stock options are settled in cash only when exercised (buy or sell).
- There exist two fundamental styles of exercising: American and European style. Speaking about stock options, they belong to American-style which means that they are exercised anytime but before the expiration time. Whereas European-style indexes are exercised only after it.
- The final trading day for both types of options is also different. For instance, third Thursday of every month is the last day to trade indexes. The third Friday of every month is the final time for stock options.
- Stock options stop trading at 4:00ET, the same time as narrow-based index options. Broad-based finish at 4:15 ET.