Like equity options, index options offer investors an opportunity either to capitalize on an expected market move or to protect holdings in the underlying instruments. The difference is that the underlying instruments of index options are indexes. These indexes can reflect the characteristics of either the broad equity market as a whole or specific industry sectors within the marketplace.
Index options enable investors to gain exposure to the market as a whole or to specific segments with one trading decision and often one transaction. An investor must make numerous decisions and transactions to obtain the same level of diversification using individual stock issues or individual equity option classes. Using index options defrays both the costs and complexities.
Unlike other investments with unlimited risk, index options offer a known risk to buyers. An index option buyer absolutely cannot lose more than the price of the option (the premium).
Index options can provide leverage. This means an index option buyer pays 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 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 bear substantially greater risk, if not unlimited.
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 way to close out a position prior to the expiration of the contract. As the common clearing entity for all U.S. exchange-traded securities option transactions, OCC resolves these difficulties.
As a result, rather than relying on a particular option writer, an option holder can rely on the system created by OCC’s Rules and By-Laws (which includes the brokers and clearing members involved in a particular option transaction) and to certain funds held by OCC.
Once OCC ensures 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 they have written. This closes out the initial transaction and terminates the seller’s obligation to deliver cash equal to the exercise amount of the option to OCC. This does not 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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Content licensed from the Options Industry Council is intended to educate investors about U.S. exchange-listed options issued by The Options Clearing Corporation, and shall not be construed as furnishing investment advice or being a recommendation, solicitation or offer to buy or sell ant option or any other security. Options involve risk and are not suitable for all investors.