Chapter 7: Options - Part II: Understanding Products and Their Risks
In this section, you’ll learn how to differentiate between equity options and index options, understand their unique characteristics, and discover how investors can effectively incorporate them into their strategies.
Detailed Explanations
Equity Options
Equity options are contracts on individual stocks. They give the holder the right, but not the obligation, to buy or sell a specific stock at a predetermined price within a set period.
- Underlying Asset: Each equity option is based on a particular stock.
- Settlement: Equity options typically settle in shares of the underlying stock.
- Purpose: They are often used to hedge stock positions or speculate on stock price movements.
Index Options
Index options, on the other hand, are tied to the performance of a stock market index rather than any single stock.
- Underlying Asset: These measure the performance of a group of stocks creating an index.
- Settlement: Index options are cash-settled, based on the index level.
- Purpose: Used for a broad market hedge, or to speculate on the market movements.
Examples
Equity Options Example
Suppose you own shares of Company XYZ and want to protect against potential losses. You could purchase a put option on XYZ stock, giving you the right to sell shares at a specified price if the stock price falls below a certain level.
Index Options Example
If an investor believes the S&P 500 index will rise, they might purchase a call option on the S&P 500 index. If the index increases as expected, the investor can sell the option at a higher price, earning a profit.
Visual Aids
graph TD;
A[Equity Options] --> B{Characteristics}
B --> E[Single Stock Basis]
B --> F[Settles in Shares]
B --> G[Hedging/Speculation]
A --> C[Example: XYZ Stock Option]
A --> D[Purpose: Protect against stock losses]
H[Index Options] --> I{Characteristics}
I --> J[Index Basis]
I --> K[Cash Settled]
I --> L[Market Hedging/Speculation]
H --> M[Example: S&P 500 Option]
H --> N[Purpose: Broader Market Approach]
Summary Points
- Equity options give rights on specific stocks and settle in shares.
- Index options are based on indices with cash settlement.
- Usage varies from speculating market trends to hedging broader portfolios.
Glossary
- Put Option: A financial contract giving the holder the right to sell an asset at a specified price within a certain timeframe.
- Call Option: A contract providing the right to buy an asset at a specified price within a given timeframe.
- Hedging: Investment strategy used to reduce risk in an asset’s price movements.
- Settlement: Process involving the delivery of the purchased financial instruments or cash consideration.
Additional Resources
- Books: “Options, Futures, and Other Derivatives” by John C. Hull
- Online Resources: Investopedia, FINRA’s official website
- Websites: Options Clearing Corporation for detailed options market insights
### Which of the following is true about equity options?
- [x] They are based on individual stocks.
- [ ] They are based on stock indices.
- [ ] They are cash settled.
- [ ] They cannot be used for hedging.
> **Explanation:** Equity options are based on individual stock assets, allowing specific stock hedging and speculation.
### What is a key characteristic of index options?
- [x] They are based on market indices.
- [ ] They settle in shares of a specific stock.
- [x] They are cash settled.
- [ ] Used only for hedging individual stocks.
> **Explanation:** Index options base on indices; they settle in cash, offering market-level hedging or speculation.
### How do equity and index options primarily differ?
- [x] By their underlying asset.
- [ ] By having the same settlement methodology.
- [ ] By having the same expiration terms.
- [ ] By being interchangeable with futures.
> **Explanation:** The main difference lies in the underlying asset: specific stocks for equity options and indices for index options.
### What settlement method is typical for index options?
- [x] Cash settlement
- [ ] Physical settlement
- [ ] Dividend settlement
- [ ] No-position settlement
> **Explanation:** Index options use cash settlement due to the broader nature of indices compared to individual stocks.
### Which purpose can both equity and index options serve?
- [x] Speculating on price movements
- [ ] Altering dividend payouts
- [x] Hedging positions
- [ ] Maximizing liquidity
> **Explanation:** Both options types are utilized for speculation and hedging but differ in their application scope.
### A call option provides the holder with:
- [x] The right to buy an asset
- [ ] The obligation to buy an asset
- [ ] The right to sell an asset
- [ ] The obligation to sell an asset
> **Explanation:** Call options grant the holder the right to purchase an asset at a predetermined price before expiration.
### What do equity options settle in?
- [x] Shares of the specific stock
- [ ] Cash by default
- [x] They are settled physically for asset delivery
- [ ] They adjust by dividend distribution
> **Explanation:** Equity options tend to settle through the delivery of actual stock shares (physical settlement).
### Who would utilize index options?
- [x] Investors looking to speculate on market indices
- [ ] Manufacturers safeguarding product prices
- [ ] Borrowers hedging interest rate changes
- [ ] Corporations altering employee stock options
> **Explanation:** Index options appeal to investors aiming to explore broader market trends versus individual stock performance.
### What is the primary purpose of settlement in options trading?
- [x] It finalizes the trading agreement by delivering assets or cash.
- [ ] It signals the start of a trading position.
- [ ] It defers risk indefinately.
- [ ] It automatically renews the contract terms.
> **Explanation:** Settlement confirms and closes the financial contract by delivering agreed assets or cash.
### True or False: Equity options can only be used for hedging purposes.
- [ ] True
- [x] False
> **Explanation:** Equity options can be used both for hedging, and speculative investing based on stock price projections.