Index Options Basics Flashcards
All of the following statements about index option contracts are true EXCEPT:
A. they are standardized contracts issued by the OCC
B. they are listed on exchanges and trade
C. they cannot be exercised - they can only be closed by trading
D. they typically have a higher notional value than stock option contracts
The best answer is C.
Index option contracts, such as the SPX (Standard and Poor’s 500 Index Option) allow an investor to bet on broader market movements, as opposed to individual stock price movements. Like stock options, they are standardized, exchange traded options issued by the OCC.
They are also useful to institutions that wish to hedge their portfolios, or that wish to generate extra income against their portfolios. They are more “potent” than individual stock options, because the value of the S&P 500 Index is so high (around 2,700), so in theory 1 contract covers 100 x 2,700 = $270,000 worth of stock. This is known as the “notional value” of the contract. So, in theory, for an institution that wishes to hedge a portfolio, fewer contracts need to be purchased (lower cost hedging).
Unlike stock options, index options are generally issued European style (exercise can only occur at expiration, not before). Exercise settlement is in cash, unlike stock options where exercise settlement results in a delivery of stock.
Like stock options, index options can be traded anytime, and trade settlement is next business day for both.
A customer has a broadly diversified stock portfolio with a current market value of $2,500,000. The customer wishes to hedge the portfolio against a market decline. The customer should:
A. sell short the exact same stock positions as those held in the portfolio
B. sell 10 SPX 2500 Calls
C. buy 10 SPX 2500 Puts
D. sell long the exact same stock positions as those held in the portfolio
The best answer is C.
Index options can be used to “efficiently” hedge a broadly diversified stock portfolio because each contract has a large “notional” value. Each SPX 2500 contract covers 2500 (index value x 100 (multiplier) = $250,000 of portfolio value. The hedge a $2,500,000 portfolio, 10 put contracts are needed. This is much easier than attempting to buy individual put contracts on the stock positions held in the portfolio.
If the market drops, the gain on the index puts offsets the loss on the physical stock portfolio.
The short sale of stock positions in the portfolio results in a “net 0” position, so there could be no further possible gain if the market rises (and no further loss if it falls). Selling the securities in the portfolio “long” would liquidate those positions – again, that is not a hedge.
Other than the OEX, virtually all index options are issued as:
A. American style options
B. European style options
C. Asian style
D. Binary style
The best answer is B.
Options contracts can either be issued as “American style” or “European style.” An American style option is one that can be exercised at any time - and equity stock options are all American style. A European style option is one that can only be exercised at expiration - not before. Almost all index options, with the exception of the OEX, are European style.
(The OEX was the first index option, and was modeled on existing American style stock options when it was issued. The CBOE then found that their institutional customers who used index options for income writing strategies against portfolios of stocks that they owned were concerned about unexpected exercises, so they kept the OEX as it was, but all later index options created, such as SPX, DJX and VIX, were European style.)
Note that listed options contracts, whether American or European style, can be traded at any time.
If the Standard and Poor’s 500 Index is falling rapidly, it would be expected that the value of the VIX would:
A. fall
B. rise
C. be stable
D. be volatile
The best answer is B.
The VIX is an extremely successful index option traded on the CBOE that is commonly called the “fear gauge.” The VIX is an index that tracks S&P 500 Index volatility. VIX values have ranged from a low of about 10 to a high of about 80 since the product was introduced in 2006.
Increased volatility occurs in falling markets, so VIX values increase when the market is falling - the index moves counter to the general market. Therefore, in a falling market, volatility increases and VIX calls become more valuable as the VIX rises; while in a rising market, VIX values tend to fall.
Like virtually all index options introduced after the OEX, the VIX is a European style option.
The exercise of an SPX (S&P 500 Index) option will result in the delivery of:
A. cash the next business day
B. cash in 2 business days
C. SPDRs the next business day
D. SPDRs in 2 business days
The best answer is A.
Unlike stock options, if there is an exercise of an index option, the writer must pay the holder the “in the money” amount the next business day. There is no physical delivery of the underlying securities in the benchmark index.
Note, for your information, that the SPDR is the S&P 500 Depository Receipt - it is one of the most popular exchange traded funds (ETFs) based on the S&P 500 Index
