Equity vs. Index Options – The Difference

         Often it is not knowing the difference between the equity and index options that stop you from taking advantage of this wonderful opportunity of investing.

          This article focuses on helping you understand the difference so that you can make the right decision.

          Options, as you may know, is a contract that you enter into, to buy or sell a specific underlying instrument or interest. Now in the case of an index option, the underlying interest would be a market index such as the NASDAQ or the S&P 500, whereas, in the equity option, the underlying instrument could be a stock, an ETF (Exchange-traded fund), or any other similar product.

          When it comes to options, in every contract, there is something called strike price (a specific price per share at which the contract can be acted upon or exercised), and an expiration date (after which the option would have no value).

          Once the contract is established the seller (or the buyer) would be obligated to sell (or buy) the shares to (or from) the buyer (the seller) at the specified strike price whenever the buyer (or seller) demands.

         You could either buy options or sell them depending upon your investment goal and the market scenario. The options that you can buy are called call options and those that you can sell are called put options.     

          Apart from the strike price, there is also something called premium, which is the price at which the contracts are traded. While strike price is fixed, the premium would fluctuate on a daily basis.

Equity Option

          When you buy (or sell) an equity option, you would be obligated to buy (or sell) a specific number of shares (which is usually 100 per option) at a specified price, within a certain period of time.

           For instance, if you are buying a call option on shares of Intel at a strike price of $40 with an expiry date of April 16^th, you will be obligated to buy 100 shares of Intel (Nasdaq: INTC) at that price within that date.

           However, you would make a profit only if the premium or the trading price of the Intel stock falls down to $30 (or anything below the strike price of $40).

Index option

         With index options trading in India, you can either benefit from an expected market move or protect your holdings in primary instruments.

         Through one single trading operation, you can gain exposure to a specific segment or the whole of the market. The best part about index options is that you would know exactly what your risk is. The maximum that you can lose is the price of the option or the premium.

          Let us say you want to purchase a call option on an Index X (that has a level of 500), at a strike price of 505. Now if this 505 call option is priced at 110Rs, the cost of your entire contract would be 1.1Lac (100 shares per option x 110Rs).

          The underlying asset here is not an individual stock or set of stocks; it is the cash level of the index that is adjusted by the multiplier. So instead of investing 5LacRs(5000 x 100), you are buying the option at 1.1 Lac. 

           You save up to 3.9 Lac that you can use elsewhere. Your risk would be limited to 1.1 LacRs. Your breakeven point in case of an index call option trade would be your strike price plus the premium that you paid.

            In this case, it is 516, which is 505 + 11. So any price above 516 will be profitable for you. If the index level rises up to 530 at expiration, you can receive 1.95 Lac ((530-505) x 100) in cash by exercising your call option. Deducting the initial premium that you paid for the index option you still get to make a profit of 1.2 Lac.

            One of the best ways to ensure profits in index options is to purchase an index call as well as an index put option at the same strike price. This way you can benefit from any big movement in the underlying index, irrespective of the side that the movement takes.

             For instance, in the above case, if you bought an index call and an index put option at , your risk would be up to the extent of $2200 ().

              If the price of the index rises up at 530 and you make $2500 cash by exercising one of your index options, you still get to make a profit of $300 ($2500 – $2200).

              Index option can get you some high returns without risking much, provided you know exactly what to buy and at what price. To get these details you can rely upon the Index option tips that the experts at Real Stock Market can offer you. Sign up on Real Stock Market for the best share market recommendations.