Beginners Guide to Trading Index Options
What are index options?
Index options are derivative contracts traded on stock indices such as the Nasdaq-100® Index (NDX) or Reduced Value NASDAQ-100 Index (NQX). Index options provide investors broad based exposure to specific sectors and indices with the benefits of diversification while removing single stock risk. Index options are used for a variety of strategies, and provide flexibility with a large selection of expirations and strikes. They are suitable for both retail and institution to hedge portfolio risk, generate options premium and speculate. NDX index options leverage the full value Nasdaq-100 Index while the NQX contracts provide 1/5 the notional exposure to the same flagship index.
ETF vs. Index Options
Many investors find index options simpler to manage compared to stock or ETF options. Index options are European style and cash settled as there are no deliverables for the underlying. This lowers transaction costs by removing the requirement to close out positions at expiration to avoid assignment. NDX Index options also offer both AM (monthly) and PM (Weekly) settlement and can be traded until 4:15PM EST on expiration day. Additionally, under section 1256 of the Tax Code, firms trading certain exchange-traded Broad-Based Index options, such as Nasdaq-100 Index Options (NDX, NQX), may receive favorable tax treatment.
For traders, two major differences that beginners should be aware of are dividends and contract size. ETFs pay dividends and are American style, which adds additional risk of early exercise on a dividend capture. Indices do not pay dividends and are European style, removing this risk. Moreover, ETFs typically trade at a fraction of their corresponding index value, creating smaller notional value contract sizes compared to index options. NDX index option contracts are much larger at $765,455 and NQX, $153,091 at the time of publish for this article.
The combination of high index values and large notational contract size are ideal for credit spread traders. Seeking high probability credit vertical spreads with enough option premium to overcome transaction costs requires a large number of strikes on broad based indices, easily found on NDX and NQX index options. Additionally, with cash settlement credit spread traders find managing expirations extremely straightforward.
Speculation - Bet on a significant increase or decline of the Nasdaq-100 Index in the future
Bullish Strategy - Buying Call Options and Bull Call Spreads is a strategy investors use looking to profit from an expected significant rise in the level of the NASDAQ-100 Index (NDX, NQX) over the term of the options contract or to hedge a short market position with limited risk.
Bearish Strategy - Buying Put Options and Bear Put Spreads is a strategy investors use looking to profit from an expected significant decline in the level of the NASDAQ-100 Index (NDX, NQX) over the term of the options contract or to hedge a long market position with limited risk.
Income - Collect option premium based on a mild directional view of the Nasdaq-100 Index in the future
Bullish Strategy - Selling Bull Put Spreads is a strategy investors use looking to profit from an expected mild rise in the level of the NASDAQ-100 Index (NDX, NQX) over the term of the options contract with limited risk.
Bearish Strategy - Selling Bear Call Spreads is a strategy investors use looking to profit from an expected mild decline in the level of the NASDAQ-100 Index (NDX, NQX) over the term of the options contract with limited risk.
Hedging - Protect a portfolio against a market correction while remaining invested
Catastrophic Protection (Cheaper insurance) - Buying OTM Put Options (30 Delta) is a strategy investors use to protect a portfolio from a major market decline in the level of the NASDAQ-100 Index (NDX, NQX)
Comprehensive Protection (Expensive insurance) - Buying ITM Put Options (60 Delta) is a strategy investors use looking to profit from a moderate market decline in the level of the NASDAQ-100 Index (NDX, NQX)
Index options provides exposure for both retail and institutional investors to broad based indices such as the Nasdaq-100 index for speculation, income and hedging purposes. Cash settled index options provide efficiencies to transaction costs and profits with favorable tax treatment. Moreover, European style options transform busy and intensive expiration Fridays to relative ease by removing assignment risk. Combined with the contract size, investors selling short dated options for income can find enough premium and stability in index options such as the Nasdaq-100 (NDX) index options and Reduced Value Nasdaq-100 (NQX) traditionally not available on ETFs.
The information contained herein has been prepared without regard to any particular investor’s investment objectives, financial situation, and needs. Accordingly, investors should not act on any recommendation (express or implied) or information in this material without obtaining specific advice from their financial advisors and should not rely on information herein as the primary basis for their investment decisions.
Neither the information nor any opinion expressed shall constitute an offer to sell or a solicitation or an offer to buy any securities, commodities or exchange traded products.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.