Index options are not that different from the more traditional options on stocks. In fact they are remarkably similar. For one, they both offer both calls and puts as the two investment choices. Secondly, they both offer a variety of strike prices on the underlying "security" (security in the case of the index being the index itself). The only defining difference is the fact that one type of option is based on the stock of an individual company while the other is based upon an index of stocks as whole. Understanding that difference and why it is important is the key to understanding Index options and their place in your investment portfolio.
All of the basic information for options in general applies just as easily to index options. For a primer on that information see the section that deals on options in general. So above and beyond that information what is it you need to know about Index Options and why would you want to invest in one?
What You Need to Know
Index options are NOT always on the recognized indexes. In fact, there are many that target specific sectors or industries and these can be very useful for an investor wanting to capitalize on the growth of either of those areas of the market.
Leverage is the most important benefit of investing in Index options. Since they allow an investor to invest a relatively small amount of money for a potentially large return. The price of the option moves proportionately to the index, which results in big price changes in the option in even moderate moves of the index.
The other primary benefit of Index Options is that they allow you to diversify among an entire market or sector with a relatively small outlay and without the many decisions, which would be needed if the same objective were pursued with individual stocks. Thus, an Index Options allows for an easy and affordable way to invest in the market as a whole with a lessened need for research. (NOTE -- One should still research the general market and economy at the very least. Investing without research is always ill advised.)
The value of an Index Option is not related to any specific number of shares but is instead related to the value of the index multiplied by some predetermined dollar (usually $100) amount.
Why Should You Invest in Index Options
You don't have the time or the inclination to research individual stocks but feel confident in research regarding a general market move in one direction or another.
You want to take advantage of the growth of a specific industry or sector of the economy but no one company has emerged as a leader.
You have a need for diversity in your portfolio and feel safer diversifying in the stock market as an aggregate as opposed to diversifying among other individual stocks.
You understand them well and you know the risk and you understand their place in your investment portfolio.
Information is for educational and informational purposes only and is not be interpreted as financial or legal advice. This does not represent a recommendation to buy, sell, or hold any security. Please consult your financial advisor.