Section 5.5 – Option Value, Index Options & Settlement Rules

  • 🔹 The Value (Premium) of an Option

    • The premium is the price of an option contract.

    • It has two components:

      1. Intrinsic Value – The amount the option is in the money (ITM).

      2. Time Value – The portion of the premium based on time remaining until expiration.

    👉 Formula:

Premium = Intrinsic Value + Time Value

🔹 Index Options Overview:

  • An index option is based on a market index, not a specific stock.

  • These can represent either:

    • Broad-based indices: Cover the overall market (e.g., S&P 500, S&P 100, Dow Jones).

    • Narrow-based indices: Focus on a single industry (e.g., banking, technology).

🔹 How Index Options Work:

  • The strike price represents the level of the index.
    Example: If the S&P 500 (SPX) is at 5230, strike prices may be 5200, 5225, 5250, etc.

  • Intrinsic value works the same as equity options:

    • Calls: ITM if index > strike.

    • Puts: ITM if index < strike.

  • Each index option contract represents $100 times the index value.

  1. 💰Cash Settlement:

    • No stock is delivered — instead, the writer pays the holder cash equal to the in-the-money amount × $100 per contract.

🔹 Example – SPX Call:

  • Investor owns 1 SPX Jan 5200 Call @ 3.

  • Index = 5210 → 10 points in the money.

  • Contract cost = 3 × $100 = $300.

  • Breakeven = Strike + Premium = 5200 + 3 = 5203.

  • Gain = (5210 – 5203) × $100 = $700.

  • If exercised, the writer pays $1,000 (10 points ITM × $100) in cash settlement.

🔹 Hedging with Index Options:

  • Investors can use broad-based index puts to protect portfolios from market downturns.
    → For example, buying an S&P 500 put helps offset losses if the market drops.

Options

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Options 〰️

🔹 Option Trade vs. Option Exercise (Settlement)

Event / What Happens / When (Settlement)

  • Option trade (buy/sell) / Buyer pays the premium to seller / Next business day (T+1)

  • Exercise of equity call (long call) / Buyer pays strike × shares to seller / Next business day

  • Exercise of equity put (long put) / Buyer delivers stock to writer and receives strike × shares / Next business day

  • Exercise of index option / No stock delivered — writer pays cash = ITM × $100 per contract / Next business day

🔹 Style of Exercise

  • American-style can be exercised Anytime before or on expiration

  • European-style can be exercised Only on expiration day

    • 📝 Note: Most index options (like SPX) are European-style, while most equity options are American-style.

Next Section

✺ Review questions ✺

  • A. Intrinsic value and strike price
    B. Intrinsic value and time value
    C. Market value and dividend yield
    D. Time value and exercise price
    ✅ Answer: B – Premium = Intrinsic value + Time value.

  • A. 3 points
    B. 7 points
    C. 10 points
    D. 5 points
    ✅ Answer: C – It’s 10 points in the money (5210 – 5200).

  • A. With delivery of the underlying stock
    B. With cash equal to the in-the-money amount × $100
    C. With delivery of index shares
    D. With margin deposits
    ✅ Answer: B – Index options settle in cash.

  • A. $100
    B. $300
    C. $700
    D. $1,000
    ✅ Answer: D – 10 points × $100 = $1,000.

  • A. American can be exercised any time; European only on expiration day.
    B. European can be exercised any time; American only on expiration day.
    C. American and European are both cash-settled.
    D. European options are illegal in the U.S.
    ✅ Answer: A – American = anytime; European = only on expiration day.