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What are the Best Tips for Index Option Trading?

Jim B.
Jim B.

Index option trading refers to the trading of options to buy and sell index securities, which are based on groupings of individual stocks in a particular sector of the market. Like all option trading, it revolves around the buying and selling of calls, which give the option buyer the right to buy 100 shares of a particular index at a future date, or puts, which allow the buyer to sell 100 shares of the underlying index. Buyers who partake in index option trading should be focused on volatile indexes, because a big, favorable price move is what they're seeking. Sellers of index options should focus on controlling the strike price, which is the price at which the option may be exercised by the buyer.

Options trading can be a lucrative process for those who have the ability to predict the movement of stocks and the timing to know when to buy their options. Most people think of option trading in terms of stocks underlying the options, but index option trading is based on the indexes that chart the movement of groupings of securities. Such trading allows investors to expose their portfolios to an entire sector of the market.

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No one should undertake index option trading before first learning the basics of options. An option buyer pays a premium, which is the price owed to an option seller, for the right to buy or sell 100 shares of an underlying security. This option may only be exercised by the buyer when the strike price, which is set below the underlying price of the security for puts and above it for calls, is reached. It may also only be exercised prior to a predetermined expiration date. Holders of options may also wish to sell their contract at some point, a process known as closing out the option.

Those who wish to be buyers on the index option trading market should not be afraid of a particularly volatile index, as the only risk to the buyer is the premium paid. For example, if someone buys a call on a certain index and the price plummets, the person will lose only the initial amount of the contract. Should the index soar in price, however, the buyer's profit can be huge. Buyers should also be ready to close out their position at the first sign of a price reversal.

Sellers of option contracts are exposed to much more risk, as they must be ready to cover the contract if an option goes heavily in the money. For that reason, index option trading requires sellers to adjust the strike price according to the volatility of the index in question. If the index is volatile and prone to big swings, the seller should create a wide gap between the current price and the strike price. On the other hand, a steady index may embolden a seller to keep the strike price close to the current price, which would command a higher premium payment from buyers.

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