Options on indexes

In short

A friend of mine once asked why her index option settled in cash when she had expected to get shares. You have probably wondered the same thing, and it is a fair question. An index option is a contract whose value follows a stock index, such as the S&P 500, and it settles in cash, never in shares. Many index options are European style, which means they can only be exercised at expiration, though not every one is, so read the contract specs before you trade. The price of one contract is the quoted premium times a multiplier, and the multiplier is set by the exchange for each product. Your gain or loss is a cash amount, taxed under rules you should check with the IRS before you place a trade. Before any trade, write down your worst case loss in dollars. If you cannot say it out loud, you are not ready to place the order.

The whole of it

What it is

I once watched a neighbor try to explain options to his teenage son over a plate of ribs. He got tangled up, and the boy lost interest. So let me try it plainly.

If you are holding a handful of stocks, you know the feeling of wishing you could say something about the market as a whole. An index option lets you do that. An index is a list of stocks that gets turned into a single number. The S&P 500 follows 500 large American companies. An option on that index is a contract that gains or loses value as the number moves.

There are two kinds. A call gains when the index rises. A put gains when the index falls. The person who buys the contract pays a price called the premium. The person who sells it takes in that premium and takes on the risk.

Here is the part that trips folks up. You cannot own an index. There is nothing to deliver. So when the contract ends, money changes hands and nothing else. That is cash settlement. No shares show up in your account.

Now, a word of respect for the reader. You did not come here to be lectured, and I will not do it. You came because you want to understand how these contracts behave so you can decide for yourself.

How it works

A friend of mine bought a call and watched the index climb all week, and he was sure he had won. Then he learned about the multiplier, and the final number surprised him. So let us walk through the machinery.

Every index option has a multiplier. It turns the quoted premium into dollars. The exchange that lists the product sets it, and you can find it in the contract specifications on the exchange website. Cboe Global Markets lists specs for its index products there.

Next comes the strike price. That is the index level written into the contract. A call with a strike of 5,000 pays off if the index finishes above 5,000. A put with that strike pays off if the index finishes below it.

Then comes style. A European style option can only be exercised at expiration. An American style option can be exercised any time before. Many broad index options are European style. Check each product, because they differ.

At expiration, the settlement value is compared to your strike. If your option is in the money, you get the difference times the multiplier, in cash. If it is out of the money, it expires worthless. Zero. That is the whole loss for a buyer.

Sellers have a harder road. A seller of an uncovered call can lose far more than the premium taken in. Your broker will have rules and margin requirements for that, and they exist for a reason.

The numbers, and where to find yours

If you are holding an account that allows options, you have probably seen a long form your broker made you sign. That form asks about your experience and your goals. It is worth reading slowly.

Here are the numbers that matter, and where each one lives. The multiplier and the settlement style are in the contract specifications from the exchange that lists the option. The current premium is on your broker's option chain. Margin requirements are set partly by the Financial Industry Regulatory Authority, known as FINRA, and partly by your broker, who can ask for more than the minimum.

For the risks of options in general, the Options Clearing Corporation publishes a document called Characteristics and Risks of Standardized Options. Your broker is required to give it to you. Read it once. You will be glad you did.

Some index options get special tax treatment under Section 1256 of the Internal Revenue Code. The rules on that depend on the product, so confirm with IRS Publication 550 or a tax professional. The rate that applies to those gains is the current figure, which the official source publishes each year, and the site will show the verified figure and its source.

A worked example

Let me tell you about a woman named Carol. She is a retired schoolteacher, careful with money, and she likes to check her math twice.

Carol is looking at a call option on an index. The index sits at 5,000. She picks a call with a strike of 5,050. The premium is quoted at 20.00. The multiplier is 100.

First, what does it cost her? She multiplies the premium by the multiplier. That is 20.00 times 100, which equals 2,000 dollars. So Carol pays 2,000 dollars, plus any commission her broker charges. That 2,000 dollars is the most she can lose on this trade.

Now the option expires, and the index finishes at 5,120. Is she in the money? Yes. The index is above her strike of 5,050. The gap is 5,120 minus 5,050, which equals 70 index points.

She multiplies the gap by the multiplier. That is 70 times 100, which equals 7,000 dollars. This is what she receives in cash at settlement.

Her profit is what she received minus what she paid. That is 7,000 minus 2,000, which equals 5,000 dollars. Before commissions and taxes, Carol is up 5,000 dollars.

Now picture the other road. The index finishes at 5,030 instead. That is below her strike of 5,050. The option expires worthless. She receives nothing. She is out the 2,000 dollars she paid.

And one more road, the tricky one. Say the index finishes at 5,060. It is above her strike by 10 points. She receives 10 times 100, which equals 1,000 dollars. But she paid 2,000. So her result is 1,000 minus 2,000, which equals a loss of 1,000 dollars. She was right about the direction and still lost money.

Carol thought about that third road for a good while. That is the lesson. Being right is not always enough. The index has to move far enough to cover the premium.

Where it goes wrong

I once knew a man who believed he had found a sure thing. He had not. Nobody does. Let me tell you where good people stumble.

The first trap is the multiplier. Folks see a premium of 20 and think it costs 20 dollars. It does not. It costs that number times the multiplier. Always do the multiplication before you click.

The second trap is time. An option loses value as expiration gets closer, all else equal. This is called time decay. You can be right about where the index will go and wrong about when, and still lose.

The third trap is leverage. A small move in the index can mean a big swing in the option price, in both directions. That cuts both ways. It feels fine going up. It feels awful going down.

The fourth trap is selling without a plan. A seller takes in a small premium and can face a very large loss. Brokers set margin rules because of this. Do not treat the rules as a nuisance.

The fifth trap is taxes. Treatment can differ between products. Some index options fall under Section 1256 and some do not. Do not assume. Check.

The sixth trap is a quiet one. Cash settlement can happen at a number you did not expect. Some index options settle on the opening level on the day of expiration, and others on the closing level. Read the specs. It matters.

Questions to answer before you leave this page

Can you state, in dollars, the most you could lose on the trade you are thinking about, including the multiplier and any commission? Do you know whether your contract is European or American style, and when exactly it settles? Have you read the Characteristics and Risks of Standardized Options document from the Options Clearing Corporation? Do you know how your broker treats margin if you plan to sell an option rather than buy one? Have you checked IRS Publication 550, or asked a tax professional, about how gains on your particular index product are taxed? And if the index finishes just a little above your strike, would you still be able to live with a loss on the trade?