What is an Index Call? Overview of Index Call Options

A derivatives contract known as a "index call" has an index as its underlying asset, such as the S&P 500 or the Nifty 50. The 50 most liquid and highly capitalized stocks listed on the NSE (National Stock Exchange) of India make up the widely followed Nifty 50 index in the Indian stock market. The right to purchase a specific number of the underlying index units at a set price, or strike price, on the option contract's expiration date is granted by an index call. In order to exercise their right to purchase the underlying index at the lower strike price and sell it at the higher market price, releasing a profit, the holder of the index call option anticipates that the price of the underlying index will increase above the strike price before the option expires.

On the other hand, if the holder decides to exercise the option, the seller of the index call, also referred to as the "writer," is required to sell the holder the underlying index. In order to avoid having to sell the index for less than it is worth, the writer is hoping that the index price will stay below the strike price.

Index Options and Their Significance

Index options are a significant component of the derivatives market, particularly in India, where they offer traders and investors the opportunity to speculate on the movements of well-established indexes such as the Nifty, Sensex, Bank Nifty, and more. These financial instruments derive their value from changes in the underlying index, making them a versatile tool for various trading and investment strategies.

Types of Index Options

Index options can be classified in different ways, which include:

1. Index Call and Put Options:

• Index Call Option: This type of option provides the holder with the right to buy the underlying index at a predetermined strike price. It is typically used when a trader has a bullish view on the index's future performance.
• Index Put Option: Conversely, an index put option grants the holder the right to sell the underlying index at a specified strike price. Traders use index put options when they anticipate a bearish trend in the index.

2. In-the-Money (ITM), Out-of-the-Money (OTM), and At-the-Money (ATM) Options:

• ITM Options: In-the-Money index options are profitable if exercised. For instance, if you hold an Nifty 15,800 call option, it is considered ITM when the Nifty index is trading above 15,800.
• OTM Options: Out-of-the-Money options are not profitable if exercised. In the example above, the Nifty 15,800 call option would be OTM if the Nifty index is below 15,800.
• ATM Options: At-the-Money options have a strike price that is very close to the current market price of the index.

3. Expiry Periods:

• In India, index options are available with different expiry periods. Typically, index options are available on a monthly and weekly basis.
• Monthly options expire on the last Thursday of the month, while weekly options expire every Thursday.
   

Trading Index Options: An Example

Let's take a practical example of trading an index option:

Suppose you buy an Nifty 15,800 call option at a premium of Rs. 54. This option gives you the right to buy Nifty at a strike price of Rs. 15,800. You pay Rs. 4,050 (75 shares x Rs. 54) for one lot of this option. If the Nifty rises to 15,810 before the option's expiration, and the option's price increases to Rs. 70, you can book a profit of Rs. 1,200 (75 shares x Rs. 16).

Regardless of market fluctuations, your maximum loss in this index options trade is limited to the premium you paid, which is Rs. 4,050.
 

Volatility in Index Options

Index options tend to be highly volatile, making them attractive to traders, proprietary desks, and institutions. Their volatility is often measured using a parameter known as implied volatility (IV). Implied volatility reflects market expectations of future price fluctuations and plays a crucial role in determining option prices. In India, index options IVs typically vary from 10 (lower band) to 30 (upper band). When volatility is low, Index option IVs are in the lower band; when volatility is high, Index option IVs are in the upper band. Major economic events such as elections, monetary policies, budgets, and so on greatly shift the direction of the markets; Index option IV's are very high at the start of the event and decline dramatically at the end. Index Option traders should be aware of the current index option IVs and those in comparison to the range since volatility is a key factor in determining index option prices. It may be preferable to avoid dealing in index options altogether before significant economic events, and if one must, they should be traded using a hedged options trading technique rather than naked options.

Conclusion

Index options are essential instruments in the Indian derivatives market, offering traders and investors the flexibility to profit from, or protect against, movements on popular indexes. Understanding the various types of index options and how they work is crucial for successful trading and investment strategies in this market. Additionally, the volatility in index options can provide opportunities for traders seeking to capitalize on price movements in these highly liquid instruments.