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On 8-22-97 Scott wrote: "... can someone explain the difference
between index options and options on futures (cash index)?"
Basically an option gives the buyer the right, but not the
obligation, to buy (Calls) or sell (Puts) the underlying interest. In the
simplest case, stock call options, the option buyer has the right to
purchase the underlying stock at the strike price untill expiration. Example:
If you buy a Spt IBM 120 call, you have the right to buy 100 shares of IBM
for $120.00 eash untill the third friday in Spt. (the expiration date).
Should IBM run up to 130 before expiration you could "exercise" the option
and buy the IBM shares for 120 and imediatly sell them for 130 or $10 per
share profit (way to go!) In reality it is best to simply sell the option
to someone else and realize the profit without the double commission. An
Index option workes in exactly the same way except the underlying interest is
an index (a group of stocks) such as the S & P 500 (SPX), S & P 100 (OEX),
etc. Since it would be impractical to actually deliver one share of 500
stocks, index options always settle in cash.
Like options futures are also contracts but they obligate one
to take delivery of the underlying interest. You contract to buy corn for
"future" delivery at todays price. If the price of corn goes up you win and
you can sell the contract for a profit (or take delivery of the cheep corn if
you bake a lot). It was a logical extention of this idea to the financial
futures, stocks, bonds, currancies and indexes. As with corn, the underlying
asset has actually been purchased for future delivery and you must put up a
"good faith deposit" called the margin. Again if the underlying asset goes
up you can sell the contract for a profit.
From the above discussion you can imagin an option on a
future contract. This would give you the option to buy or sell a particular
futures contract. If you exercised the option you would buy and take
delivery of the futures contract.
The main reason one would chose to trade one or the other is
usually the size of your wallet and the amount you would be willing to risk
(loose). One could reasonably start a trading account buying index options,
and basic spreads with risk capital of $5000.00. The entry price for trading
in futures goes up considerably!
I hope this helps, it is only day one of Trading 101. The
definitions are easy to learn, the subtleties take years.
Good luck and good trading,
Ray Raffurty
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