What does this mean? You may have heard of index options and been intimidated by the idea. I want to take a page here and cover what an index is and how option on the index compare with regular options. An index is nothing more than a collection of actual stocks that usually are grouped around some kind of industry sector or commodity. They are often used to gauge the performance of the broad market or the sector or commodity they represent.

The way an index is valued varies. Some indices are what's known as price weighted where the value of the index is essentially the sum of the total value of an equal number of stocks that make up that index.

Another approach to valuation is known as capitalization weighing. In this approach, the total capitalization of each of the stocks in the index added together and divided by some divisor amount that reduces that total to some reasonable number.

It is important to understand the difference because this can affect the movement of the index for various stocks, particularly when they are higher priced stocks. Many but not all indices trade options.

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Generally speaking index option trading isn't much different than trading options on stocks. The pricing of the option is derived from the price and volatility of the underlying index. In most cases on contract still represents shares of the underlying index.

There are a few key differences with index options.

For the most part, the options we trade on stocks are American style options. Another style of options that is often found in index option trading is European style options. Here's the bottom line with European style options. The buyer of the contract may not exercise early. What this means for a seller of options is that they don't have to worry about early assignment, a potential problem if a short position gets in the money.

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Most but not all index options are European style. There are many others as well. A more complete list can be found here. Unlike most options, which cease trading on the third Friday and expire and settle on Saturday at noon, index options are quite a bit different. Failure to understand the difference between the two can be dangerous to your trading account. Most index options cease trading on the close of business the third Thursday before the third Friday.

Settlement value is calculated based on the Friday morning opening price of each of the components of the index. It is NOT based on the opening tick of the index on that Friday morning, although it may be td stock market price listed company the same price.

The settlement value for each of the indices won't typically be reported until several hours later. Why does this type of behavior pose potential problems?

Let me tell you what happened to one of my trades on the NDX. I had sold a short put spread that was doing very nicely although I hadn't reached my target closing price. Friday morning there was some news that caused a sharp sell-off and on the market open, NDX gapped down To make things worse, by mid morning, the market had recovered much of the gap down and the position would have expired out of the money had it settled on Saturday as most options do.

I learned 2 important lessons from this. Index options are cash settled.

That means if index options trading tutorial assignment were to take place, I wouldn't be forced to buy or sell the index depending on whether it's a put or call assignment. I would have to settle in cash. Let me give an example. I won't be assigned shares of the RUT because there is no actual stock.

With all the issues I listed above, one might wonder why trade index options at all? There are actually some advantages of index option trading. One advantage with index option trading is that fact that they are European style exercise. That means if ther was a case where the position went against me and I was in the money, I am not in danger forex tradex info being assigned unless I hold it until expiration.

One of the key advantages of trading broad-based index options is the tax treatment that comes with them.

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This is not intended to be an authoritative tax discussion, however most broad-based index options fall under the category of Section contracts. For index option trading in larger volumes, this can make quite a difference. Wouldn't it be nice to have the best of both worlds?

That is, the ability to trade against the broader market or specific sector and yet not have the risks associated with index option trading of the indices themselves? There is a way with ETFs Exchange Traded Funds.

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I'm not going to go into the details of what an ETF is except to say that it is essentially a stock that is backed by the stocks or commodities it represents.

As with anything you trade, understanding the product well before trading is a good idea. See more on why I trade ETF options.

Just for reference, there is a short list of ETFs, the index they track and some basic characteristics about them. There are many other ETFs that I like to trade that don't track the broad market indices but rather are sector or regional ETFs. Examples include XLF FinancialsXLE EnergyEEM Emerging Marketsand EWZ Brazilian stocks.

The nice thing about ETFs is that there are groups of them that represent the short side of a trade. This isn't as beneficial for options traders, but it's nice to know they are there anyway.

Back to Success With Options home. Check out these full length videos that contain lots of specific information about trading spread strategies at an excellent value.

I set up and discuss the trades and then follow them up with periodic reviews until they close. For more detail go to the Options Trading Videos page.

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