subject: Stock Index Options For Individual Traders [print this page] The stock index options are designed for individual traders when they are called e-minis. E-minis are small futures contracts that use the value of designated indexes as the determinant of the option value. E-minis were designed to give small investors a chance to participate in the stock index options market. They have proven to be extremely popular.
So what is a stock index option? This term refers to options on future contracts that have a value tied to the movement of a larger stock index. It is also called a stock index future and the stock index, rather than the stock, can be considered the underlier. There is not a specific individual stock or commodity that underlies the option like in other option contracts. Instead the option contract value depends on the movement of the index funds like the S&P 500, the New York Stock Exchange composite fund, the Russell 2000 or the Nasdaq-100.
When the option is exercised, the settlement must be made in cash. Since there is no underlying commodity contract or stock for settlement, it is only cash that can be used. Stock index futures are popular and are traded on a number of global exchanges. Stock index options serve the same purpose as other types of options - for speculation and for hedging.
Comparing to Fair Value
The stock index futures market has a different term for the value of the futures contract - fair value. Fair value is based on a formula that uses several factors like the current index level and the contract expiration date. When an options contract is trading in the market place below the fair value it is said to be trading at a discount (kind of like being out of the money). When the options contract is trading in the market place above the fair value it is said to be trading at a premium (somewhat like being in the money).
The stock index options have a number of advantages. As mentioned, leverage is one of them. Index options offer leverage because the premium paid for the option contract is usually quite small and a fraction of the value of the index. When the index price moves up, the option holder will realize a gain that is a multiple of the index gain in terms of percentages.
The option holder can also choose an index of interest that reflects a broad market or a specific market sector. But one of the best features of the index options is that buyers can only lose their premiums so risk of loss is managed.
Strategies
Like other types of options, you can use a number of strategies to manage index options with the goal of limiting risk. Stock index option traders use a lot of charts to manage their trading. There is a whole set of terms used in this type of options trading too. For example, there are Bollinger bands and oscillators.
Like all options trading, you should never attempt stock index options trading unless you understand the terms and how the market works. Developing the right strategies that fit your investment style is the right approach. It is never wise to jump into any kinds of options trading without first laying the foundation for understanding the market. Do your homework first and trading second.
by: EeLynn Lee
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