Stock index options are based on a stock index rather than on specific stocks. The value of index calls increase as the index increases, and the value of index puts increases as the underlying index decreases. These options are similar to stock options, but with some important differences.
Because these options are based on indexes, there is greater diversification, and usually less volatility than with specific stocks. An index is never going to drop to zero, and it will never increase as dramatically as some specific stocks can, especially within a short period of time. Therefore, the risk is more limited, but so is the profit potential. Also, contract adjustments are rarely needed for a stock index. For instance, stock splits of stocks within the index do not affect the index, and thus, no adjustments on the contracts are needed.
The strike price is based on an index value multiplied by the multiplier of the contract, which is usually $100 (USD). These options are settled by the exchange of cash, not securities, which, for obvious reasons, is called a cash settlement. The option writer who is assigned an exercise pays cash to the holder who exercised the option.
Many index options are American-style options that can be exercised for a short time right before expiration. However, this makes little difference for options that are settled in cash, because the option holder can always sell the option on the exchanges for cash at any time before expiration. In fact, Kuala Lumpur Composite Index (KLCI) options are European-style options. They can only be exercised on the last day of trading.
The cash that is paid upon exercise depends on the index, which depends on the component prices of the index. Some contracts have AM settlement and some have PM settlement. In AM settlement, the cash settlement value is calculated using the opening component prices on the day of expiration. In PM settlement, closing prices on the day of expiration are used to determine the cash settlement value of the contract.
The cash settlement amount is determined by multiplying the absolute difference between the index and the strike price of the option times $100. For instance, SXY KO-E (2006 Nov 1375.00 Call) is based on the S&P 500 index. If the index should close at 1400 on expiration day, then a call holder would receive (1400 - 1375) x 100 = $2,500, and the assigned call writer would have to pay that much.
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