Options are contracts through which an investor can buy a stock at a specific price, also called the strike price, at a specific date, also called the expiration date. Index options are contracts on stock market indexes rather than individual company stocks. Options have no inherent value but derive their value from the underlying stock, in this case, a stock index. The most actively traded options are on the S&P 500 stock index (see http://money.cnn.com/data/markets/sandp/).

The actual cost of an index option is calculated by multiplying the price of the index by its multiplier. Most stock index options have an index multiplier of $100. The cash value of an index option contract is computed using the index multiplier. Prices of index options are quoted in dollars and cents. To arrive at the price of a single index option contract, the quoted price of the index is multiplied by the index multiplier. The option buyer will have to pay the calculated amount to purchase the option, and the option writer will receive the same amount when selling the option.

All index options are settled in cash – no stocks exchange hands. The option holder does not have the right to purchase or sell the underlying stocks of the index but is entitled to the equivalent cash value when exercising the option.

There are two ways that index options can be exercised: American-styled or European-styled. In the American-style, the holder can exercise the options anytime before expiration. European-style options can only be exercised on the last day before the expiration date.

Trading index options can be a good way to gain exposure to the entire market or specific segments of the market with one trading decision and transaction. It also allows the investors to diversify their holdings.