Benefits of Listed Index Options

Like equity options, index options offer the investor an opportunity to either capitalize on an expected market move or to protect holdings in the underlying instruments. The difference is that the underlying instruments are indexes. These indexes can reflect the characteristics of either the broad equity market as a whole or specific industry sectors within the marketplace.

Diversification
Index options enable investors to gain exposure to the market as a whole or to specific segments of the market with one trading decision and frequently with one transaction. To obtain the same level of diversification using individual stock issues or individual equity option classes, numerous decisions and transactions would be required. Employing index options can defray both the costs and complexities of doing so.

Predetermined Risk for Buyer
Unlike other investments where the risks may have no limit, index options offer a known risk to buyers. An index option buyer absolutely cannot lose more than the price of the option, the premium.

Leverage
Index options can provide leverage. This means an index option buyer can pay a relatively small premium for market exposure in relation to the contract value. An investor can see large percentage gains from relatively small, favorable percentage moves in the underlying index. If the index does not move as anticipated, the buyer's risk is limited to the premium paid. However, because of this leverage, a small adverse move in the market can result in a substantial or complete loss of the buyer's premium. Writers of index options can bear substantially greater, if not unlimited, risk.

Guaranteed Contract Performance
An option holder is able to look to the system created by OCC's Rules and Bylaws (which includes the brokers and Clearing Members involved in a particular option transaction) and to certain funds held by OCC rather than to any particular option writer for performance. Prior to the existence of option exchanges and OCC, an option holder who wanted to exercise an option depended on the ethical and financial integrity of the writer or his brokerage firm for performance. Furthermore, there was no convenient means of closing out one's position prior to the expiration of the contract.

OCC, as the common clearing entity for all exchange-traded option transactions, resolves these difficulties. Once OCC is satisfied that there are matching orders from a buyer and a seller, it severs the link between the parties. In effect, OCC becomes the buyer to the seller and the seller to the buyer. As a result, the seller can buy back the same option he has written, closing out the initial transaction and terminating his obligation to deliver cash equal to the exercise amount of the option to OCC. This will in no way affect the right of the original buyer to sell, hold or exercise his option. All premium and settlement payments are made to and paid by OCC.

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Capitalization-Weighted
An index can be constructed so that weightings are biased toward the securities of larger companies, a method of calculation known as capitalization-weighted. In calculating the index value, the market price of each component security is multiplied by the number of shares outstanding. This will allow a security's size and capitalization to have a greater impact on the value of the index.

Equal Dollar-Weighted
Another type of index is known as equal dollar-weighted and assumes an equal number of shares of each component stock. This index is calculated by establishing an aggregate market value for every component security of the index and then determining the number of shares of each security by dividing this aggregate market value by the current market price of the security. This method of calculation does not give more weight to price changes of the more highly capitalized component securities.

Other Types
An index can also be a simple average: calculated by simply adding up the prices of the securities in the index and dividing by the number of securities, disregarding numbers of shares outstanding. Another type measures daily percentage movements of prices by averaging the percentage price changes of all securities included in the index.

Adjustments & Accuracy
Securities may be dropped from an index because of events such as mergers and liquidations or because a particular security is no longer thought to be representative of the types of stocks constituting the index. Securities may also be added to an index from time to time. Adjustments to indexes might be made because of such substitutions or due to the issuance of new stock by a component security. Such adjustments and other similar changes are within the discretion of the publisher of the index and will not ordinarily cause any adjustment in the terms of outstanding index options. However, an adjustment panel has authority to make adjustments if the publisher of the underlying index makes a change in the index's composition or method of calculation that, in the panel's determination, may cause significant discontinuity in the index level.

Finally, an equity index will be accurate only to the extent that:

• the component securities in the index are being traded
• the prices of these securities are being promptly reported
• the market prices of these securities, as measured by the index, reflect price movements in the relevant markets.

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Pricing Factors
Generally, the factors that affect the price of an index option are the same as those affecting the price of an equity option: value of the underlying instrument (an index in this case), strike price, volatility, time until expiration, interest rates and dividends paid by the component securities.

Underlying Instrument
The underlying instrument of an equity option is a number of shares of a specific stock, usually 100 shares. Cash-settled index options do not relate to a particular number of shares. Rather, the underlying instrument of an index option is usually the value of the underlying index of stocks times a multiplier, which is generally U.S. $100.

Volatility
Indexes, by their nature, are less volatile than their individual component stocks. The up and down movements of component stock prices tend to cancel one another out, lessening the volatility of the index as a whole. However, the volatility of an index can be influenced by factors more general than can affect individual equities. These can range from investors' expectations of changes in inflation, unemployment, interest rates or other economic indicators issued by the government and political for military situations.

Risk
As with an equity option, an index option buyer's risk is limited to the amount of the premium paid for the option. The premium received and kept by the index option writer is the maximum profit a writer can realize from the sale of the option. However, the loss potential from writing an uncovered index option is generally unlimited. Any investor considering writing index options should recognize that there are significant risks involved.

Cash Settlement
The differences between equity and index options occur primarily in the underlying instrument and the method of settlement. Generally, when an index option is exercised by its holder, and when an index option writer is assigned, cash changes hands. Only a representative amount of cash changes hands from the investor who is assigned on a written contract to the investor who exercises his purchased contract. This is known as cash settlement.

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Option Classes
Available strike prices, expiration months and the last trading day can vary with each index option class, a term for all option contracts of the same type (call or put) and style (American, European or Capped) that cover the same underlying index. To determine the contract terms for the option class(es) you wish to employ, please contact either the exchange where the option is traded or The Options Industry Council.

Strike Price
The strike price, or exercise price, of a cash-settled option is the basis for determining the amount of cash, if any, that the option holder is entitled to receive upon exercise.

In-the-money, At-the-money, Out-of-the-money
An index call option is in-the-money when its strike price is less than the reported level of the underlying index. It is at-the-money when its strike price is the same as the level of that index and out-of-the-money when its strike price is greater than that level.

An index put option is in-the-money when its strike price is greater than the reported level of the underlying index. It is at-the-money when its strike price is the same as the level of that index and out-of-the-money when its strike price is less than that level.

Premium
Premiums for index options are quoted like those for equity options, in dollars and decimal amounts. An index option buyer will generally pay a total of the quoted premium amount multiplied by $100 for the contract. The writer, on the other hand, will receive and keep this amount.

The amount by which an index option is in-the-money is called its intrinsic value. Any amount of premium in excess of intrinsic value is called an option's time value. As with equity options, time value is affected by changes in volatility, time until expiration, interest rates and dividend amounts paid by the component securities of the underlying index.

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In order to ensure that an index option is exercised on a particular day before expiration, the holder must notify his brokerage firm before the firm's exercise cut-off time for accepting exercise instructions on that day. On expiration days, the cut-off time for exercise may be different from that for an early exercise (before expiration). Note: Different firms may have different cut-off times for accepting exercise instructions from customers, and those cut-off times may be different for different classes of options. In addition, the cut-off times for index options may be different from those for equity options.

Upon receipt of an exercise notice, OCC will assign it to one or more Clearing Members with short positions in the same series in accordance with its established procedures. The Clearing Member will, in turn, assign one or more of its customers, either randomly or on a first-in first-out basis, who hold short positions in that series. Upon assignment of the exercise notice, the writer of the index option has the obligation to pay this amount of cash. Settlement and the resulting transfer of cash generally occur on the next business day after exercise.

Note: Most firms require their customers to notify the firm of the customer's intention to exercise at expiration, even if an option is in-the-money. You should ask your firm to thoroughly explain its exercise procedures, including any deadline your firm may have for exercise instructions on the last trading day before expiration.

AM & PM Settlement
The exercise settlement values of equity index options are determined by their reporting authorities in a variety of ways. The two most common are: PM settlement ? Exercise settlement values are based on the reported level of the index calculated with the last reported prices of the index's component stocks at the close of market hours on the day of exercise.

AM settlement ? Exercise settlement values are based on the reported level of the index calculated with the opening prices of the index's component stocks on the day of exercise.

If a particular component security does not open for trading on the day the exercise settlement value is determined, the last reported price of that security is used.

Investors should be aware that the exercise settlement value of an index option that is derived from the opening prices of the component securities may not be reported for several hours following the opening of trading in those securities. A number of updated index levels may be reported at and after the opening before the exercise settlement value is reported. There could be a substantial divergence between those reported index levels and the reported exercise settlement value.

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In the case of an American-style option, the holder of the option has the right to exercise it on or at any time before its expiration date. Otherwise, the option will expire worthless and cease to exist as a financial instrument. It follows that the writer of an American-style option can be assigned at any time, either when or before the option expires, although early assignment is not always predictable.

A European-style option is one that can only be exercised during a specified period of time prior to its expiration. This period may vary with different classes of index options. Likewise, the writer of a European-style option can be assigned only during this exercise period.

Exercise Settlement
The amount of cash received upon exercise of an index option or when it expires depends on the closing value of the underlying index in comparison to the strike price of the index option. The amount of cash changing hands is called the exercise settlement amount. This amount is calculated as the dif-ference between the strike price of the option and the level of the underlying index reported as its exercise settlement value, in other words, the option's intrinsic value, and is generally multiplied by $100. This calculation applies whether the option is exercised before or at its expiration.

In the case of a call, if the underlying index value is above the strike price, the holder may exercise the option and receive the exercise settlement amount. For example, with the settlement value of the index reported as 79.55, the holder of a long call contract with a 78 strike price would exercise and receive $155 [(79.55 ? 78) x $100 = $155]. The writer of the option would pay the holder this cash amount.

In the case of a put, if the underlying index value is below the strike price, the holder may exercise the option and receive the exercise settlement amount. For example, with the settlement value of the index reported as 74.88 the holder of a long put contract with a 78 strike price would exercise and receive $312 [(78 ? 74.88) x $100 = $312]. The writer of the option would pay the holder this cash amount.

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Basic Strategies
The versatility of index options stems from the variety of strategies available to the investor. The most basic uses of index options are explained in the following examples. These examples are based on hypothetical situations and should only be considered as examples of potential trading approaches. Other strategies that might be used with equity options, such as spreads and straddles, can be employed with index options. For more detailed explanations, contact your brokerage firm or the exchanges where index options are traded.

Note: For purposes of illustration, commission and transaction costs, tax considerations and the costs involved in margin accounts have been omitted from the examples in this booklet. These factors will affect a strategy's potential outcome, so always check with your brokerage firm and tax advisor before entering into any of these strategies. For illustrative purposes, the index option positions in all of the following examples are shown to be held until expiration. The premiums are intended to be reasonable, but in reality will not necessarily exist at or prior to expiration for a similar option.

Strategy 1: Buying Index Calls

Market Outlook: Bullish over the short term

Goal: Positioning to profit from an increase in the level of the underlying index

You are anticipating an advance in the broad market or market sector measured by the underlying index in the near future. You want to take an aggressive position that can provide a great deal of leverage. This decision is made with the understanding that there is a possibility you may lose the entire premium you pay for the option.

An index call option gives the purchaser the right to participate in underlying index gains above a predetermined strike price until the option expires. The purchaser of an index call option has unlimited profit potential tied to the strength of advances in the underlying index.

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Assume the underlying index that interests you is symbolized as XYZ and is currently at a level of 200. You decide to purchase a 6-month XYZ 205 call for a quoted price of $4.75 per contract. Your net cost for this call is $475 ($4.75 x 100 multiplier). You are risking $475 if the underlying index level is not above the strike price of 205 when the XYZ call expires. The break-even point (BEP) at expiration is an XYZ index level of 209.75 (strike price 205 + premium paid $4.75) because the call will be worth its intrinsic value of $4.75, which is what you originally paid for it. The higher the XYZ index settlement value is above the break-even point at expiration, the greater your profit.

Possible Outcomes at Expiration

1. XYZ index level above the break-even point (209.75):

If at expiration XYZ index has advanced to 215, the XYZ 205 call will be worth its intrinsic value of $10 (settlement value 215 ? strike price 205). Your net profit in this case would be $525 (settlement amount $1000 received from exercise ? net cost of call $475).

Buy XYZ Index 205 Call at $4.75 with Index at 200
Net Cost for Call = $475

*Exclusive of commissions, transaction costs and taxes.

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If at expiration XYZ index has advanced to 207, the XYZ 205 call will be worth its intrinsic value of $2.00 (settlement value 207 ? strike price 205). You could exercise the option and receive the settlement amount of $200 ($2.00 intrinsic value x 100 multiplier). This amount would be less than the net amount paid for the call ($475), but it would offset some of that cost. The net loss in this case would be $275 (net cost of call
$475 ? settlement amount $200 received from exercise). This loss represents a little more than half of your initial investment.

3. XYZ index level below strike price (205): If at expiration XYZ index has declined to 198, the call would have no value because it is out-of-the-money. You will have lost all of your initial investment, a net of $475. The net premium paid for an index option represents the maximum loss for an option purchaser. Note: No matter how far XYZ declines below the strike price, the loss will not exceed $475.

Strategy 2: Buying Index Puts

Market Outlook: Bearish over the short term

Goal: Positioning to profit from a decrease in the level of the underlying index

You are anticipating a decline in the broad market or market sector measured by the underlying index in the near future. You want to take an aggressive position that can provide a great deal of leverage.

This decision is made with the understanding that there is a possibility you may lose the entire premium you pay for the option.

An index put option gives the purchaser the right to participate in underlying index declines below a predetermined strike price until the option expires. The purchaser of an index put option has substantial profit potential tied to the degree of declines in the underlying index.

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Possible Outcomes at Expiration

1. XYZ index level below the break-even point (191.10):

If at expiration XYZ index has declined to 185, the XYZ 195 put will be worth its intrinsic value of $10 (strike price 195 ? settlement value 185). Your net profit in this case would be $610 (settlement amount $1000 received from exercise ? net cost of put $390).

2. XYZ index level between strike price (195) and break-even point (191.10):

If at expiration XYZ index has declined to 193, the XYZ 195 put will be worth its intrinsic value of $2.00 (strike price 195 ? settlement value 193). You could exercise the option and receive the settlement amount of $200 ($2.00 intrinsic value x 100 multi-plier). This amount would be less than the net amount paid for the put ($390), but it would offset some of that cost. The net loss in this case would be $190 (net cost of put $390 ? settlement amount $200 received from exercise). This loss represents a little less than half of your initial investment.

3. XYZ index level above strike price (195): If at expiration XYZ index has advanced to 202, the put would have no value because it is out-of-the-money. You will have lost all of your initial investment, a net of $390. The net premium paid for an index option represents the maximum loss for an option purchaser. Note: No matter how far XYZ advances above the strike price, the loss will not
exceed $390.

Buy XYZ Index 195 Put at $3.90 with Index at 200
Net Cost for Put = $390

*Exclusive of commissions, transaction costs and taxes.

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Important Note: Options involve risk and are not suitable for all investors. For more information, please read the Characteristics and Risks of Standardized Options.

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