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Posted on 07 June 2012.
Index options can be lucrative investments for those who know how to use them. In order to make informed decisions, however, you must first understand what an index option is and how it works. At its core, an index option is like any other type of option. Like all options, it is a type of derivative contract. The contract specifies a future transaction between the buyer and the issuer of the option. The contact states the terms of the transaction such as what will be sold, the price at which it will be sold and when the transaction will take place. Depending on the type of contract, the transaction can take place any time up to the date of maturity. Some contracts list specific transaction dates while some are more open-ended. An option is very similar to a futures contract, which also specifies the price and date of a future transaction. Unlike a futures contract, however, an option buyer is never obligated to complete the transaction. At the time of maturity, they can choose whether or not they want to sell.
The transaction outlined in an options contract can refer to the exchange of a number of types of financial securities. While many options deal with specific stocks or assets, index options deal strictly with indexes. Because of this, index option settlements are always paid in cash. This is a valuable quality for many investors, as cash finalizes the transaction. Cash has a consistent value and can be used to fund other investments of the investor’s choosing.
Investors can apply a number of strategies to an index option transaction. Index puts, index calls, index collars and index straddles can all be used to increase potential returns. Investors can also increase their odds by choosing a contract that offers greater flexibility. While some index options allow the transaction to take place only once the option has reached maturity, others allow sales throughout the term of the contract.
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