What is Index Options and its Types?

In the Indian options market, it is the index options that are a lot more popular and liquid. Just as a stock is an option on a stock, the index option is an option on a well-accepted index like the Nifty, Sensex, Bank Nifty, etc. What are index options and how do they work? Apart from the index options definition, let us also look at what is index options conceptually. Here is a quick take on what are index options, the types of index options, and how and when to apply the same.

Index Options and its Types

Index Options are the derivative instrument, which means their value is derived from the movements in the underlying index. In India, there are popular indexes like the Sensex, Nifty, Bank Nifty, Nifty Financial Services. Supposed you want to take a view on these indices rather than on individual stocks, you can use index options. You can also use index options to protect your portfolio by using contrary index options as a hedge.

Normally, index options are available where the futures are already available so there is a benchmark for option pricing. Then the lot sizes, strike prices, and different expiry periods are determined for the index options and once they are standardized, they are ready and all set to trade. Unlike futures which is a kind of discrete product where either the buyer gains or the seller gains, the trader in index options is a lot more asymmetric in nature. That means; the buyer of the index options only pays the premium and that also represents their maximum possible loss.

Understanding Nifty options with an example

Data Source: NSE

The above is the Nifty call options contract on a strike price of Rs.15,800 when the nifty spot value is at 15,772 in the NSE. This is a right to buy Nifty at an exercise price of Rs.15,800 without the obligation to buy. However, to get this right without the obligation is a privilege you need to pay a price. Currently, the price you need to pay for this right is Rs.54 and the price keeps constantly changing depending on the view on the Nifty future movement.

What happens if you buy the Nifty 15,800 call option at Rs.54? Nifty has a minimum lot of 75 shares of Nifty so that is the bare minimum you need to buy. So, buying one lot of Nifty 15,800 call option (right to buy at 15,800) will cost you Rs.4,050. Remember that the options contract will expire on the last Thursday of June which is 24 June. So, you have just 2 days left to close the position at a profit. In the meanwhile, if the Nifty falls sharply, you may not get anything and lose the entire Rs.4,050.

If the Nifty goes up to 15,810 on Wednesday and the Nifty option goes up to Rs.70, then you book a profit of Rs.1,200 (75x16) on the trade and walk out with a profit. Either way, your maximum loss on this index options trade can never be more than Rs.4,050. Of course, when you add up the brokerage and statutory charges, you would find that the minimum loss is higher than that but that is the whole idea.

Types of index options

Let us quickly go one step ahead and look at the types of index options. The index options classification can be done in 3 ways as under.

• Among the index options, an index call option is a right to buy the index and an index put option is a right to sell the index. The former is a bullish view while the latter is a bearish view.
• You can also classify index options as being ITM / OTM / ATM options. In the money or ITM options are the index options that are profitable if exercised. OTM options are not profitable if exercised. To simplify, if You are holding the Nifty 15,800 call option, the option is ITM if Nifty is at 15,810 but it is OTM if Nifty is at 15,790.
• Currently, Indian markets permit the trading of index options on the Nifty and Bank Nifty on a monthly and weekly options basis. The monthly options expire on the last Thursday of the month while the weekly options expire every Thursday.

What are the options?

Options are a right to buy or sell an underlying asset without the obligation to buy or sell that underlying asset. The underlying cannot just be an asset like equities or commodities, but also notional assets like indices and currencies. The buyer of the option has the right without the obligation for which he pays the premium. The seller of the option has the obligation without the right for which he receives the premium.