In the dynamic landscape of financial markets, index options have carved a special place as a versatile financial instrument. The value of index options is derived from an underlying index. In the context of India, they serve as an investment option for well-established indices like the Nifty, Bank Nifty, and Sensex. They enjoy widespread popularity and liquidity in the options market.
Index options can be viewed as an opportunity for investors to take part in strategic hedging and leveraging the collective movement of multiple stocks represented by these indices. Understanding their workings and trading strategies can empower you as an investor to navigate market fluctuations with confidence. In this article, we will discuss what index options are in detail, what index option trading is, its advantages, and how it works in India.
What is an index option?
Index options are derivative financial instruments. Their value is based on an underlying index, which is a collection of stocks. This index could be a specific sector-based index or a broad-based index. Index options allow for a diversified approach in trades. As an investor, holding an index option entitles you to trade (buy or sell) the value of the concerned index at the predetermined price.
Index options are a good alternative to trading in individual stocks if you want to hold positions that span different industries, as index options provide all the benefits of portfolio diversification. They are versatile and help investors hedge their portfolios in the market.
In the Indian markets, some of the well-accepted indices include Sensex, Bank Nifty, Nifty, and Nifty Financial Services. You can use index options when you want to take a position on these indices instead of the individual stocks. Furthermore, these financial instruments can give you crucial opportunities for hedging.
In most cases, index options are offered alongside existing futures so that there is a standard for pricing options. Later, strike prices, lot sizes, and expiry periods are decided upon for index options. Once a benchmark is set, they are made available for trading. Index options are more asymmetric in nature than futures, where either the buyer or seller stands to gain. In other words, as an index option buyer, you only pay the premium, which represents the maximum loss you will possibly incur.
Key characteristics of index options
With a clear understanding of what is an index option, let us now take a look at the primary characteristics of index options:
- Leverage: By enabling you to control a considerable amount of conceptual value with a comparatively small investment, index options offer an impressive level of leverage
- Hedging instrument: To shield your underlying stock portfolio from any losses, index options can be used as a hedging tool.
- Dual strategy: By providing bullish and bearish approaches, index options help you profit from upward and downward market trends.
Index option trading
After discussing index options, let us understand what index options trading is. Index options enable contract holders to buy or sell at a predetermined price on the underlying index before the contract’s maturity. The index’s value is reflective of the options contract’s value.
Index options trading involves buying and selling options contracts based on major stock indices in India, such as the Nifty, Sensex, or Bank Nifty. The value of these option contracts is based on the movements of these underlying indices.
Traders in the financial market can buy call options to profit from expected increases in the index. Conversely, you can utilise put options to benefit from expected falls. Taking such positions allows investors to hedge existing positions in a diversified manner.
Types of index options
Index options can be categorised in the following three ways.
- In index options, the right to buy an index is known as an index call option, whereas the right to sell the index is known as an index put option. A call option signifies a bullish view and a put option represents a bearish view.
- Index options can also be grouped as In-the-Money (ITM), Out-the-Money (OTM), and At-the-Money (ATM). Among the three, only ITM options are considered to give gains if exercised.
- At the moment, Indian capital markets only approve the trades of index options on Nifty and Bank Nifty, which are done weekly or monthly. Weekly options expire every Thursday, and monthly options expire on the last Thursday of each month.
How does index options trading in India work?
Index options trading involves three factors: strike price, value of the underlying index, and expiration date of the contract.
- Call options: Call options give you the right—but not the obligation—to purchase the underlying index at the given strike price on or before the expiry date.
- Put options: Put options give you the right—but not the obligation—to sell the underlying index at the given strike price on or before the expiry date.
On the expiry date, the contract is either settled or simply expires. The difference between the strike price and the value of the underlying index on the expiration date determines the profit or loss for the buyer or seller.
Also read: How to do Nifty Intraday options trading
Valuation of index options
The value of index options is determined from the movement in indices like Nifty, Bank Nifty, Nifty Financial Services, and Sensex in India. Valuation of index options includes
- Spot price of the underlying index
- Strike price
- Days to expiry
- Risk-free rate
- Stock price volatility
- Dividend
The Black-Scholes model of options pricing is used to calculate the value of index options. The values above are inserted in the equation to compute the call or put premiums. Estimating dividends is one of the most prominent issues in index option valuation. This is because calculating the dividend with precision involves knowing and weighing each stock's dividend in relation to its weight in the index. Such computations are typically run by large financial institutions.
Valuing options involves pricing the call or put premium. This can be done using methods like binomial trees, replicating portfolios with hedge ratios, and Vanna-Volga pricing. These approaches help estimate the fair price of options based on different market conditions and variables.:
Example of an index options trade
Let us use an example of a Nifty call option to understand the mechanism of index options. This particular contract has a strike price of Rs. 20,000, where the Nifty spot value is Rs. 19,800 on NSE. You can get the right to buy it at Rs. 20,000, but you aren’t obliged to do so. However, to avail of this privilege, i.e., the right without obligation, you need to pay a premium. As of now, you need to pay a fee of Rs. 100 to acquire the right, and this price could vary based on the movements of Nifty futures.
The minimum number of shares available for purchase is 75, which is the minimum requirement to buy Nifty 20,000 (right to buy at Rs. 20,000). This lot of 75 shares at Rs. 100 will cost Rs. 7,500. Before the expiry date, if the Nifty takes a dive, there is a possibility that you may end up losing the entire amount of Rs. 7,500. Alternatively, if the Nifty shows an upward trend before the expiry date, you can settle the trade and secure a profit. In any scenario, your maximum loss on such a trade will not exceed the given premium of Rs. 7,500. However, you might have to consider brokerage and statutory charges that might add to the minimum loss.
Index options strategies
In India, several strategies are employed while trading in index options, but the above-mentioned call or put options are the ones that are commonly preferred.
Some of the other common strategies that are utilised with index options include:
- Bull call spread: This entails purchasing a call option at a lower strike price and shorting a call option at a comparatively higher strike price. The higher strike call is sold far out of the money, which reduces the overall strategy cost. This approach limits potential profits if the index rises but minimises the initial investment and offers capital protection.
- Bear put spread: This involves purchasing a put option at a higher strike price and shorting a put option at a lower strike price. This strategy is used when you expect a decline in the underlying index’s price. Keep in mind that the same index must be used by both the puts, and they should also have identical expiration dates. Profits are made as the index declines.
- Hedging: Hedging portfolios through purchasing index put options is also a popular insurance strategy among investors.
- Sell covered call options: On an index, selling covered call options involves purchasing the index and then selling call options against it. Investors benefit from increases in the index, and it can also be sold at the strike price if the index goes above it.
What are the advantages of index options?
There are many reasons why index options can be beneficial. Some of these include the following:
- Gains: Index options give you a chance to make profits from the movements of stocks, which includes both the rising and falling trends of the market.
- Hedging: You can use index tools to hedge so that you can safeguard your underlying portfolio from any losses.
- Leverage: Even with a small investment, leverage in index options can give you considerable returns.
Conclusion
Index options trading in India is a well-controlled and popular investment avenue. You can find a roster of index option trading contracts listed under the Bombay Stock Exchange (BSE) and National Stock Exchange to make lucrative gains using market fluctuations. However, before you buy index options, study the market thoroughly to embrace a productive strategy to minimise risks and get the most out of your pledged money.
