# Index Options: A Guide to Benchmark Index Contracts

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## What Is an Index Option?

An index option is a financial derivative that gives the holder the right (but not the obligation) to buy or sell the value of an underlying [index](https://www.investopedia.com/terms/i/index.asp), such as the S&P 500 index, at the exercise price. Index options are [cash-settled](https://www.investopedia.com/terms/c/cash-settled-options.asp) and usually [European-style options](https://www.investopedia.com/terms/e/europeanoption.asp), meaning they settle only at maturity with no early exercise.

Index options are used by traders to take advantage of index movements, hedge against losses from other investments, and diversify their portfolios. Popular index options are SPXW and VIX.

### Key Takeaways

*   Index options are cash-settled derivatives that provide the right, but not the obligation, to trade the value of a benchmark index, like the S&P 500, without buying or selling actual stocks.  
*   These options are typically European-style, meaning they can only be exercised at expiration, offering a structured risk profile by capping losses to the premium paid.  
    
*   Investors use index options as a strategic tool for hedging portfolio risks or speculating on index movements, with noted strategies like long calls, straddles, and protective puts.  
    
*   Unlike trading individual stocks, index options often use index futures as the underlying security, making them a secondary derivative with their own unique expiration dates and risk considerations.

## Delving Deeper Into Index Options

Index [call](https://www.investopedia.com/terms/c/calloption.asp) and [put](https://www.investopedia.com/terms/p/putoption.asp) options are popular tools used to trade the general direction of an underlying index while putting very little capital at risk. Index call options can earn unlimited profits, but the risk is limited to the premium paid.

For index put options, the risk is also limited to the premium paid, while the potential profit is capped at the index level, less the premium paid, as the index can never go below zero.

Beyond potentially profiting from general index-level movements, [index options](https://www.investopedia.com/articles/optioninvestor/10/etf-options-v-index-options.asp) can be used to diversify a portfolio when an investor is unwilling to invest directly in the index's underlying stocks. Index options can also be used to [hedge](https://www.investopedia.com/terms/h/hedge.asp) specific risks in a portfolio.

### S&P 500 and VIX

The busiest index options in the U.S. market are options on SPXW (representing the S&P 500) and VIX, the Cboe Volatility Index.

Note that while [American-style options](https://www.investopedia.com/terms/a/americanoption.asp) can be exercised at any time before expiry, index options tend to be European-style and can be exercised only on the expiration date.

Rather than tracking an index directly, most index options actually utilize an index futures contract as the underlying security. An S&P 500 futures contract option is a second derivative because futures are already derivatives of the index.

Both options and futures have [expiration dates](https://www.investopedia.com/terms/e/expirationdate.asp) and unique risk/reward profiles, adding more variables to consider. These index options have a multiplier, which determines the total [premium](https://www.investopedia.com/terms/p/premium.asp), or price paid. Usually, the multiplier is 100. The S&P 500, however, has a 250x multiplier.

## Practical Example: How Index Options Work

Imagine a hypothetical index called Index X, which currently has a level of 500. Assume an investor decides to purchase a call option on Index X with a [strike price](https://www.investopedia.com/terms/s/strikeprice.asp) of 505. If this 505 call option is priced at $11, the entire contract costs $1,100_—_or $11 x the multiplier of 100.

The contract's underlying asset is not individual stocks, but the index's cash level adjusted by the multiplier. In this example, it is $50,000, or 500 x $100. Instead of investing $50,000 in the stocks of the index, an investor can buy the option at $1,100 and utilize the remaining $48,900 elsewhere.

The risk associated with this trade is limited to $1,100. The break-even point of an index call option trade is the strike price plus the premium paid. In this example, that is 516, or 505 plus 11. At any level above 516, this particular trade becomes profitable.

If the index level is 530 at expiration, the owner of this call option would [exercise](https://www.investopedia.com/terms/e/exercise.asp) it and receive $2,500 in cash from the other side of the trade, or (530 – 505) x $100. Less the initial premium paid, this trade results in a profit of $1,400.

## What Are Index Options Strategies?

Common index options strategies include (1) long call/long put, (2) covered call/protective put, (3) straddle, and (4) strangle.

## How Are Index Options Taxed?

Because traders are unlikely to hold options for more than a year, these instruments are taxed as short-term capital gains. However, broad-based index options are taxed according to the 60/40 rule: 60% of the gains are treated as long-term gains, and 40% as short-term gains, regardless of the holding period. These tax advantages give broad-based index options an advantage over other options instruments.

## What Are You Actually Buying When You Trade Index Options?

When you trade an index option, you are actually buying the right to buy or sell a futures contract on the underlying index. Since these futures are themselves derivatives, an index option can be considered a second derivative of the underlying index.

## The Bottom Line

Index options provide traders with a strategic way to gain exposure to the entire market through a single financial instrument, offering them the potential for portfolio diversification. These options are European-style, settled in cash, and are exercised only at expiration, distinguishing them from American-style options.

The profit potential for index call options is unlimited, while the risk is limited to the premium paid; for put options, the potential profit is capped. Common strategies include long call/put, covered call/protective put, straddle, and strangle, each with unique risk/reward profiles.

Understanding the cash-settlement process, expiration dates, strike prices, and tax implications is crucial for trading index options successfully.  

> **Article Sources**
>
> 1.  Cboe. "[Most Active](https://www.cboe.com/us/options/market_statistics/most_active/)."
>     
> 2.  Nasdaq. "[Understanding the Tax Advantages of Index Options](https://www.nasdaq.com/articles/understanding-tax-advantages-of-index-options)."