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Index option is a type of option trading where in the underlying asset is an Index or a ‘basket of selected stocks’. You can choose from Nifty 50 Index, NSE Nifty Midcap 50, NSE NIFTY IT Index, or NSE Bank Nifty Index, to name a few. These indices come with a specified set of stocks, each of which has a weight attributed to it. The weights of these stocks and their CMPs are used to calculate such indices.
Index options come in different lot sizes, expiry periods and strike prices. The profit or loss that you make in index option trading would be non-linear, depending upon the movement in the corresponding index. Instead of the full notional value, you only get to pay the premium when you buy an index options lot. This premium would be very nominal when compared to the actual index contract value.
Most index options traded in Indian NSE are of Bank Nifty Options and Nifty Options. The risks, rewards and payoffs that apply for these options are the same that apply to the other call and put options. There are 4 things you need to keep in mind while trading in index options:
If you own an index call option you get the right to buy that index at a specified price within the expiry date and if you own an index put option you get the right to sell the index at a specified price within the expiry date. You would want to consider the difference between the current market price and the strike price of the index before exercising your right and taking the position of the underlying security. You may not want to exercise your call option if the current market price is lower than the strike price. Similarly, you may not want to sell your put option if the current market price is higher than the strike price. When you don’t exercise your right, the option tends to stand expired.
Buying an index call option is called a bullish strategy while buying an index put option is termed as a bearish strategy. The amount of profit that you make in an index option depends on the increase or decrease the underlying index undergoes when compared to its strike price. At the same time the financial risk that you take would be limited to the amount of premium that you pay for the option.
The basic strategies in index option trading include buying the put and call indexes. Nevertheless, here are a few advanced strategies:
In this strategy you buy an index call option as well as an index put option at the same strike price. You exercise your right depending on the increase or decrease of the price of the index option as compared to the strike price. If the movements are big, you can make huge profits. At the same time your losses would be pre-determined right at the time when you enter into the contract and would be limited to the premium that you pay.
In this strategy you sell your index calls while purchasing an equal number of index put options simultaneously. The premium that you make by selling calls will end up financing the cost of buying the index puts, at least in part, depending on the level of index and strike price chosen. This way the value of your portfolio would be protected against any kind of adverse movements in the market.
An index option can limit your losses, while providing you a steady income, especially if you are a long-term investor. If you are looking at getting an assured amount of profit, it would be a good idea to check out our royal option services. Our experts would be happy to answer any query you may have about the same.