In India, there are some popular benchmark indices which list stocks according to a special category like bank indices or other sectoral indices. Indices or any index of stocks, may also list stocks according to market-capitalisation of the companies that generate the stocks.
In options trading, the basic idea of index options is that an options contract is traded with an underlying asset being an index, instead of a set of particular stocks of one company or a commodity, or any other security. Knowing what an index is and some basic details of options will let investors have a background of what index options entail.
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In the simplest terms, an index reflects a method to monitor the performance of a set of assets in an effective and standardised manner. Indices measure the performance of a group of assets (stocks) and this is meant to replicate a particular area of the stock market. So, in the most basic way, an index is a particular collection of stocks that are based on certain characteristics.
In Indian stock market trading, the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) have robust indices to track certain market sectors or the overall market in general. Therefore, you may have sectoral indices like the Nifty Bank, BSE Healthcare, etc. Furthermore, there exist benchmark indices which consist of the Nifty 50 index (50 top-performing stocks) or the BSE Sensex index (30 top-performing stocks). An index such as either of these acts as a benchmark (a standard) index to track the best stocks in the market. Both these are regarded as benchmark indices as they prove to be reliable in terms of how the Indian stock markets typically work. From this, readers may have understood that index options are those in which the underlying security of an options contract is the whole index. However, a better understanding of this is necessary to grasp how indices in options work.
The term option means a financial instrument (a contract or an agreement between parties) based on the value of an underlying asset/security like stocks. Options contracts are agreements between buyers and sellers that give them the chance to purchase or sell the underlying asset stipulated by the contract. It is the underlying asset that is either bought or sold. Every options contract specifies a particular fixed price at which underlying assets must be bought or sold by a certain stipulated expiry date or before that date. The price that is fixed or stated by any options contract is known as the strike price. In any given options contract, the buyer or seller entering the contract has the right to exercise the contract, but is under no obligation to do so.
After reading the information thus far, you may well ask, “What is an index option?”. In plain language, an index option is an options contract giving the holder of the contract the right to buy or sell an underlying asset which is an index at a predetermined price at a stipulated date of expiry. The value of the index reflects the value of the options contract. Again, like any other underlying asset in options contracts, the holder is under no obligation to exercise the contract by the date of expiry.
In index options contracts, investors and traders take positions on an index, rather than on a group of stocks or any other assets. An index option stands for a financial derivative contract that derives value from the underlying stock market index. The index, as mentioned before, could be a broad-based index such as the Nifty 50 and the Bank Nifty in India. Investors make use of index options if they prefer to take positions on indices rather than on particular stocks. Index options can be very useful for hedging with contradictory index options, thereby keeping a portfolio safe.
Index options, in most cases, are offered when futures are already in the markets. This offers a benchmark that reflects option pricing. Once the strike prices, lot sizes and numerous dates of expiry are fixed and defined, index options are made available for trading. Similar to options contracts with any other underlying asset, index options contracts have buyers only making premium payments in case they opt out of index options contracts before or on the date of expiry. This premium payment is the extent of loss for the buyer of an index options contract. The options contract seller must fulfil the demand of the options buyer as they are getting the premium from the options buyer.
Options trading in India, whether investors trade on an index or any other underlying asset that contracts stipulate, offers investors a fair deal of flexibility and tracking the way the market moves. In a sense, options, with their low cost of entry, offer new traders ways to mitigate their risk, yet earn lucratively if the contract is exercised. However, in the case of any trading and investing, investors must do their homework and invest according to their own objectives and financial plans.