Introduction to index options

Index options are a versatile financial tool for engaging with the broader stock market. Unlike single-stock or exchange-traded fund (ETF) options tied to individual securities, index options derive their value from market indices like the S&P 500 (SPX), Nasdaq 100 (NDX), and Russell 2000 (RUT). Whether you’re an investor or trader, you can potentially use index options to speculate on market trends, hedge portfolio risk, or implement advanced strategies—without directly buying or selling individual stocks, ETFs, or their options.

Index options stand out from single-stock and ETF options with unique features that simplify trading. They’re cash-settled, eliminating physical delivery of shares, and are typically European-style, exercisable only at expiration. Also, traders can potentially benefit from 60/40 tax treatment and the certainty of automatic settlement. Additionally, the ability to trade until market close provides flexibility and reduces the likelihood of early position closeouts, making index options a practical choice for many strategies.

Understanding the mechanics of index options is essential before getting started. Whether you're seeking to manage risk, capitalize on market opportunities, or explore advanced strategies, this guide will walk you through the basics, showcase their unique features, and clarify how index options differ from other options—empowering you to use these tools with confidence.

An index measures the performance of a specific group of investments, like stocks, bonds, or commodities. Stock indexes such as the SPX, NDX, and RUT track a basket of stocks, helping investors understand market trends and sentiment. Indexes aren’t limited to stocks—they can also represent other asset classes like bonds, commodities, volatility, real estate, or currencies, making them versatile tools for analyzing markets and the economy.

Stock indexes have evolved significantly since Charles Dow created the first one in 1884 to track railroad stocks. Over time, broader indexes like the S&P 500 and international benchmarks emerged, allowing investors to follow markets and sectors with greater precision. Today, indexes play a central role in investing, powering ETFs, mutual funds, and derivatives like options and futures. They help investors manage risk, speculate, and gain exposure to specific parts of the market—all with a single tool.

Index options became available in the early 1980s, a period marked by rapid innovation in financial markets. The Chicago Board Options Exchange (Cboe), established in 1973 as the first options exchange in the United States, played a pivotal role in creating and popularizing index options. Initially focused on equity options, Cboe expanded its offerings to include options on stock market indexes, recognizing a growing need for tools that could provide broad market exposure and risk management.

In 1983, Cboe launched the first index option based on the S&P 100 (OEX), quickly followed by SPX options which were based on the S&P 500. These products allowed traders and investors to speculate on or hedge against market-wide movements rather than focusing solely on individual stocks. The introduction of index options was groundbreaking because it revolutionized the way investors approached the market. Unlike traditional stock options, index options are cash-settled and tied to the performance of a specific benchmark, simplifying their use for portfolio management.

Over time, Cboe continued to innovate by adding options on other indexes, such as Nasdaq 100 (NDX), the Russell 2000 (RUT), and the Cboe Volatility Index (VIX). These products became essential tools for both institutional investors and retail traders, offering flexibility and efficiency for a variety of strategies, including hedging, speculation, and advanced options spreads. Today, index options remain a cornerstone of the options market

An index option is a unique type of option, with its value derived from broad-based market indices rather than individual stocks or ETFs. At Robinhood, index options are available on popular benchmarks such as SPX, NDX, RUT, and VIX. Additionally, the S&P 500 Mini Index (XSP), which is 1/10th the size of SPX, is also available. View the full list of available index options here. Similar to single-stock and ETF options, index options come in two forms:

• Call options: Provide the right, but not the obligation, to buy the underlying index at a specified price.
• Put options: Provide the right, but not the obligation, to sell the underlying index at a specified price.

Just as with other options, when purchasing an index option, you pay a premium calculated as the option's current price multiplied by a standard contract multiplier (typically 100) and the number of contracts traded. Selling an index option allows you to collect this premium in exchange for assuming the obligation to fulfill the contract if the buyer exercises it. However, selling options or option spreads requires cash collateral, which reduces your available options buying power. Selling index options, in particular, is considered one of the riskiest strategies due to the unlimited potential losses if the market moves sharply against your position.

Also, with the appropriate approval levels in your options account, many of the strategies remain the same—long calls, long puts, debit spreads, credit spreads, iron condors, and more. A key limitation though is that certain strategies involving shares and options, such as covered calls, are not possible with index options since indexes do not have physical shares.

Similar to standard options, each index option has a defined expiration date. Index options offer frequent expirations, including weekly and even daily options, while less actively traded indexes may only have monthly expirations. Of course, traders can close their positions before expiration, just as they would with equity options, by selling or buying back the contracts. The profit or loss is determined by the difference between the premium paid or received when opening the trade and the premium at the time of closing.

Additionally, the key factors that influence index options pricing are the strike price, time to expiration, and the current index level (spot price). At expiration, the relationship between the strike price and the spot price determines whether an option is in the money (ITM), at the money (ATM), or out of the money (OTM). ITM options have intrinsic value. OTM options, on the other hand, have no intrinsic value and typically expire worthless. ATM options, being closest to the current index value, derive most of their value from time value before expiration.

Another critical component in pricing index options is implied volatility, which reflects the market's expectations of future price swings in the index. Higher implied volatility increases an option’s premium, as it can signal a greater likelihood of significant price movements. Tools like the VIX, which measures implied volatility in SPX options, provide traders with a gauge of overall market volatility.

Together, these factors work in tandem to determine the value of index options, making their pricing mechanics straightforward yet dynamic for traders to navigate. As with all options markets, actual option prices are ultimately shaped by the push and pull of buyers and sellers in the market. As participants trade options, their activity adjusts prices in real time, aligning them with current market conditions, sentiment, and expectations. This interplay between theoretical values and real-time demand ensures option prices dynamically reflect the ever-changing market landscape.

Index options differ from single-stock and ETF options in several ways, including:

1. Cash settlement: Since an index is a calculated value and not a tangible asset, there’s no actual stock or asset to deliver at expiration. Instead, any gains or losses are settled in cash, based on the difference between the index level at expiration and the option's strike price.
2. European style: While stock and ETF options settled American style, meaning they can be exercised at any time prior to expiration, most index options are European style and can only be exercised at expiration. (OEX is one of the few exceptions, as it settles American style. Note: OEX isn't available to trade at Robinhood)
3. 60/40 Tax treatment: Index options are subject to a 60/40 tax treatment under Section 1256 of the U.S. tax code. This means that 60% of gains are taxed at the lower long-term capital gains rate, while the remaining 40% are taxed at the short-term rate, regardless of the holding period.
4. Certainty of settlement: Index options don’t have contra-exercise, meaning they’re automatically settled in cash at expiration if they’re in the money. This simplifies the process for traders and eliminates the risk of missing an exercise deadline. Additionally, sellers can be confident they won’t face assignment prior to the expiration or due to extended-hours trading, as index options are settled based solely on the official closing value (for PM settled options) or opening value (for AM settled) of the underlying index.
5. Trade until the close: One advantage of trading index options is that they can typically be traded right up until market close on their expiration day. Unlike stock or ETF options, index options are cash settled and don’t carry the risk of physical delivery. As a result, traders are less likely to face early closeouts from a brokerage firm's risk management team, allowing them to maintain their positions longer and better manage their strategies into the closing bell.

Because index options are based on broad market segments rather than individual stocks, index options are often seen as a cost effective and efficient way for investors to gain or hedge exposure to the market, minimizing the need to manage multiple individual positions. Index options serve three primary purposes for traders and investors:

1. Speculation: Traders can use index options in an attempt to profit from anticipated market movements. For example, if you expect the market to rise you can use bullish options strategies, like buying calls and call spreads, or selling puts and put spreads. Conversely, if you expect the overall market to fall you can use bearish strategies, such as buying puts or put spreads, or selling calls and call spreads.
2. Volatility trading: If you expect the markets to remain range-bound, you can employ neutral options strategies designed to capitalize on changes in implied volatility, such as straddles, strangles, iron condors, iron butterflies, and calendar spreads. Additionally, VIX options offer a direct way to trade volatility as a standalone asset class.
3. Hedging: You can also use index options to mitigate potential losses within a stock portfolio. For instance: Imagine you have a portfolio that closely mirrors the S&P 500. You can purchase put options on the index in an attempt to protect your portfolio against a market downturn.

Index options, like other options, carry inherent risks that new traders should carefully consider. Similar to equity or ETF options, the primary risks include the potential to lose the entire premium paid for long positions and significant losses when selling uncovered options. Additionally, options are time-sensitive, losing value as expiration approaches—a factor that requires careful attention to market timing and volatility. For index options, broader index price movements can have a significant impact on value, making it essential to align trading strategies with your financial goals and risk tolerance.

A key reminder about index options is that they are cash-settled, meaning no underlying asset is delivered at expiration. This simplifies settlement but increases the need for accurate predictions of index price movements. Index options, often tied to broad market indices, may also exhibit lower volatility than individual stocks or ETFs, potentially limiting gains but reducing risk exposure. While these features distinguish index options, the core risks—such as time decay, premium loss, and uncovered position exposure—are the same. Always review the Characteristics and Risks of Standardized Options disclosure document before trading to fully understand these complexities.

Unlike equity and ETF options, index options have some unique features that should be understood before investing in them. This includes, but is not limited to, settlement, exercise, expiration, tax, and cost characteristics. Indices are unmanaged, do not incur expenses, and cannot be invested in directly.

Index options are powerful tools for speculating on market trends, managing risk, and exploring advanced strategies. However, they come with risks similar to standard options, including potential losses and sensitivity to time decay and volatility. By understanding their mechanics, pricing, and risks, traders can more confidently integrate index options into their trading strategies while managing their exposure effectively.