What is an index option? Definition and meaning

An index option is a financial derivative that gives the holder the right (not obligation) to buy/sell a basket of stocks at an agreed-upon price before a specified date.

It is a financial derivative that represents an index of a collection of stocks.

The index option can be tied to indexes such as the S&P 500 Index, the Russell 3000 Index, the Dow Jones Industrial Average Index Options (DJX), and Nasdaq-100 Index Options (NDX). There are also tied narrow-based indexes, which are indexes that represent a specific industry (such as the technology industry or the energy industry).

Holders of a stock index option have a right to trade their security for a specific price before its expiration date. A call option allows you to purchase the index, while a pull option on an index allows you to sell it.

According to Cambridge Dictionaries Online, an index option is:

“An investment based on the value of a stock index (= a set of shares that shows the value of a stock market). The investor buys the right to buy or sell that index at a particular price by a date in the future.”

Cash-settled options

Index options are cash-settled options, which means that the holder cannot purchase or sell the underlying stocks of the index. Rather, they can request the equivalent cash value from the option writer as soon as they have exercised the option.

Index options are similar to exchange-traded funds (ETF’s), but the value of an ETF fluctuates during the trading day and an index option’s value only changes at the end of a trading day.

The price of an equity index option contract is calculated by multiplying the contract multiplier by the quoted premium amount.