Options based on indices rather than individual stocks provide investors with diversification.
In finance, a text book will tell you that diversification means the removal of unsystematic risk. However, if you've ever come across the saying "don't put all your eggs in one basket" then you have already been introduced to the concept of diversification. It basically means spreading your investment across multiple assets, in this case, multiple stocks with the objective of reducing (or evening out) your overall risk.
A stock index is a compilation of many stocks. The S&P 500 is meant to resemble a portfolio made up of 500 individual companies. Index options based off the S&P 500 (SPX) give option traders the chance to construct option strategies and techniques to bet on the entire market rather than the performance of one individual stock. The Russell 2000 is made up of 2000 small cap companies.
I don't mean to infer that index options are easy to predict. But index options are generally less volatile than the component stocks that make up the index.
Earnings reports, takeover rumors, news and other market events are what drive volatility in individual stocks. An index tends to smooth out the wild ups and downs of the stock basket and hence options based off an index will also show lower fluctuations.
Index options are very popular for option traders, hedge funds and investment firms. This popularity drives up the volumes available to trade and reduces the spreads quoted in the market. This competition means that you will always have a fair price to trade at and plenty of volume too.
European Style Expiration
All standardized equity options use American-style exercise. American-style exercise means that operationally you can exercise your contract any day that the market is open before the expiration date. The last day to exercise an American-style option is usually the third Friday of the month in which the contract expires (expiration Friday). Most index options, however, use European-style exercise. This means that the only time you can operationally exercise your contract is the last trading day (usually Friday) before expiration. Remember, even though there is only one day in which you can exercise your contract, you can always close out your option position in the secondary market any day prior to expiration. This means that you have until expiry to adjust your trade without fear of an early assignment of the underlying security.
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