Differences Between Stock Option Trading and Index Option Trading

Trading in Options is an attractive way to earn good profits while taking limited risks. The best thing about this is that even before entering into an Options trade, you will be able to calculate the maximum loss that you can suffer. This has made options a great product to trade in. Option contracts are actively used by traders in many markets across the world for speculation, hedging and arbitrage.

Key Terminologies:
Before entering into the world of Options, it would be wise for you to understand a few basic concepts.

• Option: This is a standardized contract that gives the buyer the right, but not the obligation to buy (Call) or sell (Put) an index or stock or any other financial asset (Underlying) at a predetermined price (Strike Price) on or before a predetermined date (Expiry Date).
• Call Option: This gives the holder the right, but not the obligation, to buy the Underlying at the Strike Price.
• Put Option: This gives the holder the right, but not the obligation, to sell the Underlying at the Strike Price.
• Stock Option: This is an Option where the Underlying is an individual stock of a company. These Options derive their value from the price of the Underlying Stock.

For example, a Stock Option on Reliance Shares will move in tandem with the price movement of the shares of Reliance Industries during the trading hours in the Indian Stock Markets.

• Index Option: An Equity Index is a portfolio constructed with Individual Stocks, each of which has a particular weight in the Index. For an Index Option, the underlying is either a broad market Index or a Sectoral Index. The price of the Index Option is derived from the price movement in the Underlying Index.

For example, an Index Option on Nifty 50 Index will derive its value from the movement of the nifty 50 Index of National Stock Exchange of India Ltd.

Pricing Factors:
The pricing factors for both Stock and Index Options are the same. These are: price movement of the Underlying Asset (i.e. Stock or Index), Strike Price chosen, Volatility in the Underlying, Time Remaining till Expiry, Interest Rates and Expectation of Dividends.

How Stock Index Options differ from Index Options?

Before you start trading in Options, you will have to choose between these two types of Options. So let us now get a better understanding about how Index and Stock Options differ from each other.

• Underlying Instrument:

As mentioned already, the Underlying Instrument for Stock Options is the share of an individual company. For an Index Option, the underlying is an Index, which is a basket of shares of different companies.

It is important to note that not all Indexes and Shares, that are available in equity markets in India have options contracts based upon them. Securities and Exchange board of India (SEBI) has permitted derivative contracts only on the selected few of them. From time to time indices and stocks are added and removed from this list. You can get the complete list of derivative contracts from the website of a stock exchange.

• Risk:

An Index is a diversified portfolio of different shares. So the movement of any individual stock in its portfolio will have a limited impact on the movement of the Index. Generally, the movements of the stocks cancel each other out, providing greater stability to the Index.

An Index is however subject to systematic risk. There are many macro-economic factors like economic, monetary and fiscal policy of the country, geopolitical issues and threats, inflation etc. which determine the price movement of the Index.

However, in case of Stock Options, the Underlying is the share of only one company. Hence, anything good or bad that happens to the company will have a major impact on the price of the shares. Stock Options often show heavy volatility during the earnings season, or when any news pertaining to the company is expected. And let’s not forget that they are also affected by the same macroeconomic risks that the Index Options face.

Due to this, Stock Options are considered to be somewhat riskier than the Index Options in most market conditions.

• Volatility:

In the case of Index Options, excess volatility in one of its constituent stocks is cushioned by the stability in the other stocks included in the Index. However, this benefit is not available in a Stock Option, wherein the portfolio consists of a single stock only.

Index Options are found to be less volatile than single Stock Options. This is why many traders, often choose Index Options to speculate as well as hedge their positions. Lower volatility makes them easier to manage in most cases.

However, if volatility is seen in the entire market, prices of even Index Options can fluctuate heavily. In such a scenario, smart traders look for Stock Options which are holding their ground and showing a lower volatility than the Index Options. This gives them safety as well as good returns if they use the right strategies involving these Stock Options.

Some traders who are already comfortable in trading in a particular stock also trade in option contracts on that stock. The reason is that they already know the trends and patterns of price movement of that particular stock. This will make it easier for them to trade in options on that stock. This helps them to hedge their positions in the underlying stock as well.

The Next Step: Learn Option Strategies

This basic idea about Stock and Index Options will help you to choose contracts that are right for you. Start by doing a few trades to familiarize yourself with practical option trading. Thereafter, you can learn about the plethora of option strategies that are available from an expert. With some practice, you will be able to find out which option strategy is suitable for your trading style. A good knowledge of option strategies will put you in a position to start earning well by using both Index and Stock Options to your advantage.