Stock Option Pricing
Trading a Sector Option
By FRANK KNEIPHER
Mar 6, 2007 - 5:54:00 PM

Trading a Sector Option

Index options trade and can be exercised and assigned similarly to

listed equity options; however, unlike equity options, they settle in

cash, not stock. The assigned writer (seller) is obligated to pay the

exercising holder (buyer) the difference between the closing value of the underlying index and the exercise price of the option, multiplied by the specified index multiplier (typically $100). Simply stated, the multiplier is the unit of trading for a sector option. A multiplier of 100 means that for every point a sector option is in-the-money, there is an incremental $100 of intrinsic value in the option.

Exercise Style

Sector options have either an American or European exercise style. An American-style option can be exercised at any time through the last day of trading prior to expiration. A European-style option prohibits exercise until the last business day before expiration. Whether a sector option is American- or European-style, the option can always be bought or sold prior to expiration.

Exercise Settlement Values

For some index options, the exercise settlement value is based on the closing prices of the component stocks on the last business day prior to expiration (usually a Friday). Others cease trading at the close two business days prior to expiration (usually a Thursday) as the settlement value is based on Friday?s opening prices of the component stocks. No matter which way the exercise settlement value is determined, expiration of contracts occurs on the Saturday following the third Friday of the month.  Cash, not stock, is delivered upon settlement; therefore, it is important that buyers and sellers of sector options realize that exercising an option terminates their position in the market. It is also important that investors consider the exercise and settlement features of sector options when devising a trading strategy.

FLEX Options

FLexible EXchange Options (FLEX Options) may also be available

for some index options. FLEX Options allow users to customize

their contract terms to meet specific hedging and investment needs.

Investors can specify the expiration date, strike price, exercise style

(American or European), and choice of either a.m. settlement

(reported at the opening of trading) or p.m. settlement (reported at

the close of trading). Contact any exchange or your broker to receive more detailed information about FLEX Options.

Sectors enable an investor to participate in market moves without

having to select a specific stock or group of stocks. They offer profit potential and allow investors the ability to control their exposure to market risk. Converting market insight into specific investments or trading action can be time-consuming and fraught with frustration. Deciding which stocks to purchase is a common dilemma. Sectors can provide a simpler, more efficient, and less costly means of trading. These contracts allow an investor to focus on market movement without the risk of having to be correct about a particular stock.

Sectors give traders and investors a means to adjust their positions

easily and quickly in response to market changes. An inherent risk in

any securities position is that an overall market decline may send its

price downward while an overall market increase may not advance its price upward. A defense against these risks is a sector index option. Investors can rely upon sector options to hedge diversified or industry specific portfolios during periods of market uncertainty, and to reduce risk exposure while maintaining their specific market commitment.

In summary, sector index options are used to facilitate actions based on market opinion and strategy, to enhance the potential rewards of astute judgement, or to hedge a portfolio. Anyone holding a group of stocks, whether an individual investor, a trust department, or a portfolio/fund manager, may benefit from sector index options.