TECH TUESDAY is a weekly content series covering all aspects of capital markets technology. TECH TUESDAY is produced in collaboration with Nasdaq.
“Any fool can know. The point is to understand.” -Albert Einstein
Life is good. We are so fortunate to have knowledge tools like search engines. I think about the Library of Alexandria in Egypt, which was a repository of information for the ancient world. I think about the Book of Kells in Trinity Library in Dublin.
These were homes to documents that preserved the collective knowledge of humankind throughout history. That’s now digital and available to essentially anyone with internet access. It’s mind-blowing.
There’s no equivalent to the world’s great physical libraries for those seeking information about index options trading, but indeed there is a wealth of information available online. Today, we address Google’s most asked (or searched) index options questions.
| Most-Asked Questions, per Google |
| 1. What is an index option and how does it work? |
| 2. What is an example of an index option? |
| 3. What are popular index options? |
| 4. How are index options settled? |
| 5. Why are index funds such a popular investing option? |
| 6. Are index options “better” than stock options? |
| 7. What are options trading levels? |
| 8. What determines the price of a stock? |
| 9. When is the stock market closed? |
1. What is an index option and how does it work?
Let’s start with a definition to level set: An index option is a financial derivative contract whose value is derived from an underlying stock market index.
So, examples of index options would be Nasdaq-100 Index Options (NDX), where the underlying index is the Nasdaq-100 Index (NDX).
The NDX is designed to measure the performance of the 100 largest Nasdaq-listed NON-FINANCIAL companies. The NDX includes stocks from a variety of sectors, but as mentioned Financials are excluded, and there is no “Old Energy” or Real Estate investment trusts. They are also excluded.
By contrast, an equity option references a single security like Apple or Amazon or Tesla or Netflix. Whereas the NDX includes all those securities (with different weights) and about 96 others. There’s a degree of diversification that’s different than standard equity options. There are other differences too.
An index is a measurement tool. You cannot “buy or sell” an index. It’s simply a representative number, but the derivative industry has evolved, and since the early 80s, you could buy or sell calls and puts linked to the value of an index like the NDX or S&P 500 Index (SPX).
These options often have significant notional values. For example, if the NDX measures 15,000 and an index option affords exposure to 100 units of the underlying, then the notional value of ONE call or put = $1.5M.
The large value is something that institutional clients value. They can hedge or gain exposure to an index’s value with relatively few contracts.
The problem there is that many options users were implicitly excluded from using index options because the premiums were large, and that exposure was too big for many accounts.
So, the industry began introducing smaller notional index products like Nasdaq-100 Reduced-Valued Index Options (NQX), which is 1/5th the size of the full NDX, as well as Nasdaq-100 Micro Index Options (XND), which is 1/100th the size of the full index. So, if the NDX measures 15,000, XND would be measuring around 150. Consequently, one XND option would have a notional value of ~$15k. Much more manageable for many market participants.
2. What is an example of an index option?
Great question – it goes back to the definition we started with and bears repeating.
An index option is a financial derivative contract whose value is derived from an underlying stock market index.
So, examples of index options would be NDX index options where the underlying index is the NDX.
There are also smaller notional index products based on the NDX, like NQX and XND. That’s an example of how the market for index options, historically an institutional market – meaning banks and hedge funds used them, but not many individuals – has evolved to meet demand.
There are also index options on the SPX and the Russell 2000 Index (RUT), as well as a variety of others.
A few distinguishing characteristics make index options unique compared to equity or ETF options:
| Product | Equity & ETF Option | Index Option |
| Exercise | American (early assignment risk) | European |
| Settlement | Physical – shares of underlying asset | Cash |
| Expiries | 3rd Friday for all with Weeklies (prompt six weeks every Friday) for many | Daily (much more granular) |
| Diversification | Exposure to specific equity or ETF product | Exposure to broad-based index |
| Tax Treatment | Standard capital gains* | Often: 60% long-term rate, 40% short-term rate* |
*Consult a tax professional
3. What are popular index options?
Popular is a subjective term, so I’ll answer based on average daily volumes.
The most actively traded index options include the SPX and NDX (NDX, NQX, XND). There are a variety of other index options that reference small caps, volatility, international equity markets, etc.
There are also very actively traded ETF options that track index values, but they are different in important ways from “non-equity” index options.
4. How are index options settled?
We mentioned this a bit already. The short answer is “index options are cash settled.” You cannot “physically deliver” shares of an index because the shares do not exist. An index measures.
So, let’s walk through an example to illustrate.
Let’s imagine an NDX index call option has a strike price of 15,000 and expires on Friday.
If the index value is 15,050 at expiration (there is a specific symbol to check index expiration values), then the call option would have an intrinsic value of 50 (15,050 – 15,000).
It would have a cash value of 50*100 = $5,000.00
Keep in mind that this does not account for whatever premium was paid for the option.
If you bought it for $70 and it was held through expiration, it’s worth $50. The net effect would be the buyer losing $2,000 from their account, which would be credited to the seller’s account.
There would be no exposure after expiration.
By contrast, if you bought a (similar) Invesco QQQ Trust (QQQ) option, let’s say the 365-strike call with the same expiration.
Then QQQ closes at $366.22 on expiration Friday, the owner of the 365 call would have to deliver cash ($36,500) to the call seller (strike price * 100), and the call seller needs to deliver 100 shares of QQQ into the call buyers account.
The call buyer would then be long 100 shares of QQQ, and they WOULD have go-forward risk. They would benefit if shares moved up. They would have paper losses if QQQ moved lower. Those gains or losses would not be recognized until the QQQ stock was sold.
Cliff notes: ITM index options settle to cash based on the value of the option at expiration. Cash is either credited or debited from one account to the other. No position post-expiration.
ITM equity and ETF options settle into long/short shares of the stock or ETF. There is a risk after expiration based on that stock or ETF’s performance.
5. Why are index funds such a popular investing option?
Another fantastic question without a clear-cut answer, but I’ll share my opinion briefly.
There are currently THOUSANDS of listed (available to buy/sell publicly) stocks. Micro-cap stocks, small-caps, mid-caps, large-caps and mega-caps. Biotech, banks, information technology, consumer staples, health care, telecommunications, etc. It can be overwhelming.
It’s difficult to pick a company (stock) or a handful of companies that will perform well over a variety of time frames. Many stocks are cyclical. In other words, their performance is tied to the overall domestic or international economic environment. When things are going well (growth) – stocks overall might be expected to move higher. Vice versa during or in anticipation of a contraction (recession).
Index funds, whether in a mutual fund or ETF wrapper, allow investors to gain exposure to a wide variety of equities across sectors with a single product. There’s a degree of inherent diversification. That theoretically reduces risk relative to single-name equity.
Plus, over long-time horizons, equity indexes tend to increase in value. To be clear, there are difficult years/periods (2000 – 2002, 2008 – 2009, 2021) when indexes decline. There is risk inherent in any market at all points in time.
So, in my opinion, index investing has become so common because the industry developed products that have an accessible “wrapper” for clients (ETFs, mutual funds, futures, options, etc.) that are designed to track well-known indexes. Those indexes are broad-based, so there’s inherent diversification. Plus, you can dollar cost average and potentially participate in an index that gains in value over a significant time frame.
6. Are index options “better” than stock options?
“Better” is an entirely subjective term, but it’s an example of how the words we choose frame the information we access in the “Search Engine Library” of the 21st Century.
Index options are very similar but distinct from stock options in a couple of important ways.
Index options cash settle whereas equity and ETF options are physically delivered. But what’s that mean?
Well, all options expire and if an option expires in-the-money (ITM) (meaning it has intrinsic value) then that triggers a process whereby the long option holder gets something and the short option holder delivers something.
With equity and ETF options, actual shares of the underlying are delivered.
100 shares of stock for each ITM option go from option seller to option buyer (could be long or short stock). Because the stock moves, there is a “go-forward” risk based on the stock position.
Index options are different because of their construction. An index measures, it’s not a tradeable instrument. So, you can’t “deliver” an index. As a result, ITM options all settle to cash at expiration based on their intrinsic value.
That completes the cycle of risk transfer and there is no go-forward risk.
A couple of other differences: Equity and ETF options are all American styled, whereas index options (with one exception – OEX) are European styled. Again, the question should be – what’s that mean and when does it matter?
An American styled option can be exercised (by the option holder) at a point on OR BEFORE expiration. All ETF and individual stock options are American styled, so the option seller runs the risk of being assigned early.
Early assignment may occur when an ITM call option holder is economically incentivized to collect a dividend. They would need to exercise the ITM call ahead of the ex-dividend date to be eligible for the dividend. The call seller (assigned) would end up SHORT the underlying and responsible to pay the dividend. That can be a meaningful risk.
All else equal, an American option is more valuable because there is greater “optionality” relative to a European styled option. Keep that in mind when comparing index ETF options (American style) to similar European styled index options (which cannot be exercised early).
Index options, like NDX, are European styled. European styled simply means that the option can ONLY be exercised on the option’s expiry date. Consequently, index options cannot be exercised early, which is one less potential concern for option sellers.
That doesn’t mean you have to hold an index option until expiration. Like other options, you can buy or sell to close at any point the market is open. Interestingly, some index options are available for trading overnight and most equity options are not.
So, neither is better, but understanding the idiosyncratic differences and the associated risk is important.
7. What are options trading levels?
Great question, but unfortunately, there isn’t a single answer. Trading levels or “permissions” are determined at the brokerage level. They can differ from one broker to another. The higher the inherent risk in a given strategy – the higher permission (or trading level) required.
Please consult the Options Disclosure Document (ODD) to understand the “Characteristics and Risks of Standardized Options.”
8. What determines the price of a stock?
The short answer here is “supply and demand,” but that’s a lazy answer too.
Let’s back up a bit and understand more of the process. The process of bringing a stock to market is important. The initial public offering (IPO) is the first-time shares are available to the public as the name implies. Prior to that, the company in question would be considered “privately held.”
A company may have been in business for many years before they choose to “go public.” If that decision is made, the company’s owners typically transfer some of their risk and potential reward to outside investors. Those investors likely believe in the prospect of the company’s growth.
The company gets capital (money) that’s often used to help facilitate growth or pay off debt. The company would hire an underwriter/investment bank and broker-dealer that helps facilitate the process of going public.
I’m simplifying the process here, but the underwriters work to determine a fair valuation for the new equity issuance. They determine how many shares will be sold (made available) and then back into an estimate of that offering price based on the full valuation.
For example, if a company is valued at $500M and issues 10M shares for sale, the IPO price indication would be around $50/share. This is a VERY basic breakdown and does not include important complexities.
For the sake of example, let’s say that the hypothetical company goes public. Shares start trading at $50.00, but then there’s a significant growth in investor interest. That would likely drive the share price higher.
Imagine if that same company issues a poor quarterly earnings report and negative outlook nine months later. In that situation, there would probably be significant “supply” coming to market in the form of a sell order, and the share price would likely come under pressure.
Ultimately prices are determined by the marginal buyer. A stock is worth what someone is willing to pay for it. The overriding force in the system is the supply and demand. Clearing price could be considered where the market finds “balance” at any given point in time.
9. When is the stock market closed?
The equities markets in the United States celebrate the following holidays:
- New Years Day
- MLK Day
- Presidents Day
- Good Friday
- Memorial Day
- Juneteenth
- Fourth of July
- Labor Day
- Thanksgiving Day
- Christmas Day
The actual dates change annually in some situations. For example, Memorial Day is celebrated on the last Monday in May. Good Friday depends on when Easter is celebrated.
It’s a good habit to periodically check an exchange website for the actual dates and when markets reopen.
Fixed income, commodities and other markets sometimes have different holiday closures.
Kevin Davitt is Head of Nasdaq’s Index Options Content.
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