Index Option Trading vs Stock Option Trading

Most people are familiar with trading stock and have a stock portfolio or at least an IRA or mutual fund made up of stocks.  Some others are familiar with trading stock options.  Trading stock options can be riskier than trading stocks if you don’t own the underlying shares.   If you want to mitigate your risk when trading options consider Index Options.

When most people talk about the market, they usually are referring to the Dow Jones  Industrial Average which is make up of portfolio of stocks that represent the  overall stock market.  In general, index options act the same as stock options, but there are some very specific and important differences.

Cash Settlement
The biggest difference between a stock option and an index option is the underlying asset.  For a stock option, there are underlying shares of stock that if an option is exercised, must be bought or sold.  With index options, holders cannot exercise their options for actual stock shares.  For this reason, index options are subject to cash settlement which means you receive a cash payment when you exercise an index option or you owe money if you are assigned an index option.

Another very significant difference between stock options and index options is how they are exercised.  Most stock options feature American-style exercise which means they can be assigned or exercised any time before expiration.  Most index options feature European-style exercise which means they can only be assigned or exercised the last day before expiration.  This is important because the price of an index option can move up and down, you can be in and out of the money during the course of the trading month and not be assigned or exercised.  It only matters what the strike price is on the day prior to expiration.

Stock options and index options also differ in when they expire.  Stock options expire at the close of the trading day on the 3rd Friday of the month and that is when the cash settlement takes place.  This is referred to a PM Settlement.  PM settlement values are based on the stock price at the end of the day on Friday.  While some index options use PM settlement, the majority of index options follow AM settlement.  With AM settlement, the last trading day of the trading month is the third Thursday of the calendar month.   The settlement value is based on the opening prices of the individual stocks making up the index on the third Friday of the month.  Please keep in mind that the settlement value of an index on Friday can be significantly higher or lower than the closing value on Thursday due to overnight trading elsewhere in the world.  This is referred to as gapping up or down and can make the difference between your options expiring worthless and you losing money!

Why trade index options instead of stock options?

I personally trade no more than 3 – 4 indexes each month and I trade the same indexes month after month.  I don’t spend any time researching stocks.  I don’t have to, after expiration one month I go back in and trade the same index the following month.

I am able to reduce my risk by trading index options that are made up of a portfolio of stocks.  Unanticipated announcements from a company can result in wild fluxuations in it’s stock.  With index options, if one company’s stock plumuts because they miss earnings or file for bankruptcy, or goes way up do to an unanticipated announcement it will not have a dramatic effect on the index as a whole.  Also, the price of the index cannot drop to zero as could possibly happen with an individual stock.

There is no risk of early assignment with index options.  A holder of an index option can only exercise their option on the final day before expiration.

For those reasons I am an index option trader.  I have established my strategy and I stick to it month after month.  While I continue to learn and fine tune my strategy, I don’t deviate from it.  I encourage you to take a look at index options and see if they might work for you.