A stock market index option is a type of futures contract. This, in turn, is a form of derivative. The option serves as both a form of wager on the future movement of a stock market and a tradable asset in its own right.
As with any form of options contract, a stock market index option involves one party paying a flat fee to another party to set up the contract. The first party then has the right to either buy or sell an asset, in this case a stock market index, at a fixed price. Unlike many options contracts, there is usually more flexibility in exercising this right; the trader can carry out the buying or selling at any point until a scheduled date, rather than being allowed to do so only on a specified date.
The asset for the option is a stock market index. This is an asset in its own right, but its price is not determined by specific demand and supply, but instead is simply the average of a designated list of stocks. Naturally, a person holding a stock market index option will want to exercise it when the index is at a higher value than the fixed price agreed to in the options contract, meaning he or she can sell at an immediate profit.
Compared with most futures contracts, an investor in a stock market index option has two significant advantages. First, because it is an option, he or she has the right but not the obligation to exercise the contract, thus meaning he or she doesn't have to carry out the deal if it would mean paying above the current market price. Secondy, the ability to exercise at a time of his or her choice, up until the expiry date, affords much greater opportunity to pick a profitable time to do so. These advantages are usually reflected in a high up-front fee paid to the other investor.
Investors need to check exactly what index is being used for a particular option. Sometimes these are not common indices and may, for example, only cover stocks of industries in a particular market sector. It's also important to check how the index is calculated, for example if it is weighted based on the size of each company whose stock is included.
Another significant feature of a stock market index option is that the trader can decide exercise the option at any time of day, but the price used in the deal will be the one that applies when the relevant exchange closes. This can prove a disadvantage to the trader. For example, if the index is higher than the agreed contract price but begins dropping, the trader may decide it has peaked and it is time to cash in. It's then possible that the price will have declined further by the end of the day, possibly even to the point that the trader winds up losing out from the deal.