UNDERSTANDING INDEX OPTIONS

January 2001

Table of Contents

Introduction 3

Benefits of Listed Index Options 5

What is an Index Option? 7

Equity vs. Index Options 9■ Pricing Factors■ Underlying Instrument■ Volatility■ Risk■ Cash Settlement■ Purchasing Rights■ Option Classes■ Strike Price■ In-the-money, At-the-money,

Out-of-the-money■ Premium■ Exercise & Assignment■ AM and PM Settlement■ American vs. European Exercise■ Exercise Settlement■ Closing Transactions

Basic Strategies 15■ Buying Index Calls■ Buying Index Puts

Glossary 21

For More Information 26

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This publication discusses exchange-traded optionsissued by The Options Clearing Corporation. Nostatement in this publication is to be construed as arecommendation to purchase or sell a security, or toprovide investment advice. Options involve risk andare not suitable for all investors. Prior to buying orselling an option, a person must receive a copy ofCharacteristics and Risks of Standardized Options.Copies of this document may be obtained from yourbroker, by calling 1-888-OPTIONS, or by visitingwww.888options.com. A prospectus, which dis-cusses the role of The Options Clearing Corpora-tion, is also available without charge upon requestaddressed to The Options Clearing Corporation,440 S. LaSalle St., Suite 908, Chicago, IL 60605, orto any exchange on which options are traded.

January 2001

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Introduction

The purpose of this booklet is to provide an intro-ductory understanding of index options and howthey can be used. Index options are currently tradedon the following U.S. exchanges: The AmericanStock Exchange, L.L.C. (AMEX), the ChicagoBoard Options Exchange, Inc. (CBOE), the PacificExchange, Inc. (PCX) and the Philadelphia StockExchange, Inc. (PHLX). Like trading in stocks,options trading is regulated by the Securities andExchange Commission (SEC).

These exchanges seek to provide competitive,liquid and orderly markets for the purchase and saleof standardized options. All option contracts tradedon U.S. securities exchanges are issued, guaranteedand cleared by The Options Clearing Corporation(OCC). OCC is a registered clearing corporationwith the SEC and has received a ‘AAA’ rating fromStandard & Poor’s Corporation. The ‘AAA’ ratingrelates to OCC’s ability to fulfill its obligations ascounterparty for options trades.

As referred to in this booklet, an index is ameasure of the prices of a group of securities orother interests. Although indexes have been devel-oped to cover a variety of interests such as stocksand other equity securities, debt securities and for-eign currencies, and even to measure the cost of liv-ing, indexes on equity securities (which are calledstock indexes) are among the most familiar. The fol-lowing discussion refers only to stock indexes andstock index options.

Stock indexes are compiled and published byvarious sources, including securities markets. Anindex may be designed to be representative of thestock market of a particular nation as a whole, secu-rities traded in a particular market, a broad marketsector (e.g., industrials) or a particular industry (e.g.,electronics). Indexes may be based on securitiestraded primarily in U.S. markets, securities traded

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primarily in a foreign market or a combination ofsecurities whose primary markets are in variouscountries. An index may be based on the prices ofall or only a sample of the securities whose prices itis intended to represent.

Readers who intend to trade index optionsshould familiarize themselves with the basic featuresof the underlying indexes, including the generalmethods of calculation. Readers who are attemptingto follow a precise and sophisticated strategy involv-ing index options may wish to inform themselvesabout the exact method for calculating each indexinvolved. Information regarding the method of cal-culation of any index on which options are traded,including information concerning the standardsused in adjusting the index, adding or deleting secu-rities and making similar changes is generally avail-able from the options market where the options aretraded.

While this discussion will focus on generalcharacteristics of index options, specific classes ofindex options can have slightly different productspecifications. Before investing, you should deter-mine the specific terms of each product class. Thisand other information on index options or optionproducts not included in this booklet can beobtained by contacting the appropriate exchange orThe Options Industry Council (OIC) (see pages 26and 27 for addresses, phone numbers and Websites). In addition, OCC publishes a booklet,Understanding Stock Options, which covers the basicsof exchange-listed equity options and is recom-mended to investors contemplating the use of indexoptions. This book can also be obtained either bycalling 1-888-OPTIONS or by visiting OIC’s Website, www.888options.com.

This introductory booklet should be read inconjunction with the basic option disclosure docu-ment, Characteristics and Risks of StandardizedOptions, which outlines the purposes and risks ofoption transactions. Despite their many benefits,options are not suitable for all investors. Individuals

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should not enter into option transactions until theyhave read and understood the risk disclosure docu-ment which can be obtained from their broker, bycalling 1-888-OPTIONS, or by visitingwww.888options.com. It must be noted thatdespite the efforts of each exchange to provide liq-uid markets, under certain conditions it may be dif-ficult or impossible to liquidate an option position.Please refer to the disclosure document for furtherdiscussion on this matter. In addition, marginrequirements, transaction and commission costs andtax ramifications of buying or selling options shouldbe discussed thoroughly with a broker and/or taxadvisor before engaging in option transactions.

Note: For the sake of simplicity, the calcula-tions of profit and loss amounts in this booklet donot account for the impact of commissions, transac-tion costs and taxes.

Benefits of Listed Index Options

Like equity options, index options offer the investor anopportunity to either capitalize on an expected marketmove or to protect holdings in the underlying instru-ments. The difference is that the underlying instru-ments are indexes. These indexes can reflect the char-acteristics of either the broad equity market as a wholeor specific industry sectors within the marketplace.

DiversificationIndex options enable investors to gain exposure to themarket as a whole or to specific segments of the mar-ket with one trading decision and frequently with onetransaction. To obtain the same level of diversifica-tion using individual stock issues or individual equityoption classes, numerous decisions and transactionswould be required. Employing index options candefray both the costs and complexities of doing so.

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Predetermined Risk for BuyerUnlike other investments where the risks may haveno limit, index options offer a known risk to buyers.An index option buyer absolutely cannot lose morethan the price of the option, the premium.

LeverageIndex options can provide leverage. This means anindex option buyer can pay a relatively small premi-um for market exposure in relation to the contractvalue. An investor can see large percentage gainsfrom relatively small, favorable percentage moves inthe underlying index. If the index does not move asanticipated, the buyer’s risk is limited to the premi-um paid. However, because of this leverage, a smalladverse move in the market can result in a substan-tial or complete loss of the buyer’s premium. Writersof index options can bear substantially greater, if notunlimited, risk.

Guaranteed Contract PerformanceAn option holder is able to look to the system creat-ed by OCC’s Rules and Bylaws (which includes thebrokers and Clearing Members involved in a partic-ular option transaction) and to certain funds held byOCC rather than to any particular option writer forperformance. Prior to the existence of optionexchanges and OCC, an option holder who wantedto exercise an option depended on the ethical andfinancial integrity of the writer or his brokeragefirm for performance. Furthermore, there was noconvenient means of closing out one’s position priorto the expiration of the contract.

OCC, as the common clearing entity for allexchange-traded option transactions, resolves thesedifficulties. Once OCC is satisfied that there arematching orders from a buyer and a seller, it seversthe link between the parties. In effect, OCC becomesthe buyer to the seller and the seller to the buyer. Asa result, the seller can buy back the same option hehas written, closing out the initial transaction andterminating his obligation to deliver cash equal to the

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exercise amount of the option to OCC. This will inno way affect the right of the original buyer to sell,hold or exercise his option. All premium and settle-ment payments are made to and paid by OCC.

What is an Index?

A stock index is a compilation of several stock pricesinto a single number. Indexes come in various shapesand sizes. Some are broad-based and measure movesin broad, diverse markets. Others are narrow-basedand measure more specific industry sectors of themarketplace. Understand that it is not the number ofstocks that comprise the average that determine if anindex is broad-based or narrow-based, but rather thediversity of the underlying securities and their mar-ket coverage. Different stock indexes can be calculat-ed in different ways. Accordingly, even where index-es are based on identical securities, they may measurethe relevant market differently because of differencesin methods of calculation.

Capitalization-WeightedAn index can be constructed so that weightings arebiased toward the securities of larger companies, amethod of calculation known as capitalization-weighted. In calculating the index value, the marketprice of each component security is multiplied by thenumber of shares outstanding. This will allow asecurity’s size and capitalization to have a greaterimpact on the value of the index.

Equal Dollar-WeightedAnother type of index is known as equal dollar-weighted and assumes an equal number of shares ofeach component stock. This index is calculated byestablishing an aggregate market value for everycomponent security of the index and then deter-

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mining the number of shares of each security bydividing this aggregate market value by the currentmarket price of the security. This method of calcula-tion does not give more weight to price changes ofthe more highly capitalized component securities.

Other TypesAn index can also be a simple average: calculated bysimply adding up the prices of the securities in theindex and dividing by the number of securities, dis-regarding numbers of shares outstanding. Anothertype measures daily percentage movements of pricesby averaging the percentage price changes of allsecurities included in the index.

Adjustments & AccuracySecurities may be dropped from an index because ofevents such as mergers and liquidations or because aparticular security is no longer thought to be repre-sentative of the types of stocks constituting theindex. Securities may also be added to an indexfrom time to time. Adjustments to indexes might bemade because of such substitutions or due to theissuance of new stock by a component security. Suchadjustments and other similar changes are withinthe discretion of the publisher of the index and willnot ordinarily cause any adjustment in the terms ofoutstanding index options. However, an adjustmentpanel has authority to make adjustments if the pub-lisher of the underlying index makes a change in theindex’s composition or method of calculation that,in the panel’s determination, may cause significantdiscontinuity in the index level.

Finally, an equity index will be accurate onlyto the extent that:■ the component securities in the index are being

traded■ the prices of these securities are being promptly

reported■ the market prices of these securities, as measured

by the index, reflect price movements in the relevant markets.

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Equity vs. Index Options

An equity index option is an option whose under-lying instrument is intangible – an equity index.The market value of an index put and call tends to rise and fall in relation to the underlying index.The price of an index call will generally increase as the level of its underlying index increases, and its purchaser has unlimited profit potential tied to the strength of these increases. The price of anindex put will generally increase as the level of itsunderlying index decreases, and its purchaser hassubstantial profit potential tied to the strength of these decreases.

Pricing FactorsGenerally, the factors that affect the price of anindex option are the same as those affecting theprice of an equity option: value of the underlyinginstrument (an index in this case), strike price,volatility, time until expiration, interest rates anddividends paid by the component securities.

Underlying InstrumentThe underlying instrument of an equity option is anumber of shares of a specific stock, usually 100shares. Cash-settled index options do not relate to aparticular number of shares. Rather, the underlyinginstrument of an index option is usually the value ofthe underlying index of stocks times a multiplier,which is generally U.S. $100.

VolatilityIndexes, by their nature, are less volatile than theirindividual component stocks. The up and downmovements of component stock prices tend to can-cel one another out, lessening the volatility of theindex as a whole. However, the volatility of an indexcan be influenced by factors more general than canaffect individual equities. These can range from

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investors’ expectations of changes in inflation,unemployment, interest rates or other economicindicators issued by the government and political or military situations.

RiskAs with an equity option, an index option buyer’srisk is limited to the amount of the premium paidfor the option. The premium received and kept by the index option writer is the maximum profit a writer can realize from the sale of the option.However, the loss potential from writing an un-covered index option is generally unlimited. Anyinvestor considering writing index options shouldrecognize that there are significant risks involved.

Cash SettlementThe differences between equity and index optionsoccur primarily in the underlying instrument andthe method of settlement. Generally, when an indexoption is exercised by its holder, and when an indexoption writer is assigned, cash changes hands. Onlya representative amount of cash changes hands fromthe investor who is assigned on a written contract tothe investor who exercises his purchased contract.This is known as cash settlement.

Purchasing RightsPurchasing an index option does not give theinvestor the right to purchase or sell all of the stocksthat are contained in the underlying index. Becausean index is simply an intangible, representativenumber, you might view the purchase of an indexoption as buying a value that changes over time asmarket sentiment and prices fluctuate.

An investor purchasing an index optionobtains certain rights per the terms of the contract.In general, this includes the right to demand andreceive a specified amount of cash from the writerof a contract with the same terms.

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Option ClassesAvailable strike prices, expiration months and thelast trading day can vary with each index optionclass, a term for all option contracts of the same type(call or put) and style (American, European orCapped) that cover the same underlying index. Todetermine the contract terms for the option class(es)you wish to employ, please contact either theexchange where the option is traded or The OptionsIndustry Council.

Strike PriceThe strike price, or exercise price, of a cash-settledoption is the basis for determining the amount ofcash, if any, that the option holder is entitled toreceive upon exercise. See Exercise Settlement onpage 14 for further explanation.

In-the-money, At-the-money, Out-of-the-moneyAn index call option is in-the-money when its strikeprice is less than the reported level of the under-lying index. It is at-the-money when its strike priceis the same as the level of that index and out-of-the-money when its strike price is greater than that level.

An index put option is in-the-money when its strike price is greater than the reported level ofthe underlying index. It is at-the-money when itsstrike price is the same as the level of that index and out-of-the-money when its strike price is lessthan that level.

PremiumPremiums for index options are quoted like those for equity options, in dollars and decimal amounts.An index option buyer will generally pay a total ofthe quoted premium amount multiplied by $100 for the contract. The writer, on the other hand,will receive and keep this amount.

The amount by which an index option is in-the-money is called its intrinsic value. Any amountof premium in excess of intrinsic value is called an

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option’s time value. As with equity options, timevalue is affected by changes in volatility, time untilexpiration, interest rates and dividend amounts paidby the component securities of the underlying index.

Exercise & AssignmentThe exercise settlement value is an index value used tocalculate how much money will change hands, theexercise settlement amount, when a given index optionis exercised, either before or at expiration. The valueof every index underlying an option, including theexercise settlement value, is the value of the index asdetermined by the reporting authority designated bythe market where the option is traded. Unless OCCdirects otherwise, the value determined by thereporting authority is conclusively presumed to beaccurate and deemed to be final for the purpose ofcalculating the exercise settlement amount.

In order to ensure that an index option is exer-cised on a particular day before expiration, the holdermust notify his brokerage firm before the firm’s exer-cise cut-off time for accepting exercise instructions onthat day. On expiration days, the cut-off time for exer-cise may be different from that for an early exercise(before expiration). Note: Different firms may havedifferent cut-off times for accepting exercise instruc-tions from customers, and those cut-off times may be different for different classes of options. In addi-tion, the cut-off times for index options may be different from those for equity options.

Upon receipt of an exercise notice, OCC willassign it to one or more Clearing Members withshort positions in the same series in accordance withits established procedures. The Clearing Memberwill, in turn, assign one or more of its customers,either randomly or on a first-in first-out basis, whohold short positions in that series. Upon assignmentof the exercise notice, the writer of the index optionhas the obligation to pay this amount of cash.Settlement and the resulting transfer of cash gener-ally occur on the next business day after exercise.

Note: Most firms require their customers to

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notify the firm of the customer’s intention to exer-cise at expiration, even if an option is in-the-money.You should ask your firm to thoroughly explain itsexercise procedures, including any deadline yourfirm may have for exercise instructions on the lasttrading day before expiration.

AM & PM SettlementThe exercise settlement values of equity indexoptions are determined by their reporting authoritiesin a variety of ways. The two most common are:■ PM settlement – Exercise settlement values are

based on the reported level of the index calculatedwith the last reported prices of the index’s compo-nent stocks at the close of market hours on the dayof exercise.

■ AM settlement – Exercise settlement values arebased on the reported level of the index calculatedwith the opening prices of the index’s componentstocks on the day of exercise.

If a particular component security does not open for trading on the day the exercise settlement valueis determined, the last reported price of that security is used.

Investors should be aware that the exercisesettlement value of an index option that is derivedfrom the opening prices of the component securitiesmay not be reported for several hours following theopening of trading in those securities. A number ofupdated index levels may be reported at and afterthe opening before the exercise settlement value isreported. There could be a substantial divergencebetween those reported index levels and the report-ed exercise settlement value.

American vs. European ExerciseAlthough equity option contracts generally haveonly American-style expirations, index options canhave either American- or European-style.

In the case of an American-style option, theholder of the option has the right to exercise it on orat any time before its expiration date. Otherwise, the

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option will expire worthless and cease to exist as afinancial instrument. It follows that the writer of anAmerican-style option can be assigned at any time,either when or before the option expires, althoughearly assignment is not always predictable.

A European-style option is one that can onlybe exercised during a specified period of time priorto its expiration. This period may vary with differ-ent classes of index options. Likewise, the writer ofa European-style option can be assigned only dur-ing this exercise period.

Exercise SettlementThe amount of cash received upon exercise of anindex option or when it expires depends on theclosing value of the underlying index in comparisonto the strike price of the index option. The amountof cash changing hands is called the exercise settle-ment amount. This amount is calculated as the dif-ference between the strike price of the option andthe level of the underlying index reported as itsexercise settlement value, in other words, theoption’s intrinsic value, and is generally multipliedby $100. This calculation applies whether theoption is exercised before or at its expiration.

In the case of a call, if the underlying indexvalue is above the strike price, the holder may exercisethe option and receive the exercise settlement amount.For example, with the settlement value of the indexreported as 79.55, the holder of a long call contractwith a 78 strike price would exercise and receive $155[(79.55 – 78) x $100 = $155]. The writer of theoption would pay the holder this cash amount.

In the case of a put, if the underlying indexvalue is below the strike price, the holder may exer-cise the option and receive the exercise settlementamount. For example, with the settlement value ofthe index reported as 74.88 the holder of a long put contract with a 78 strike price would exerciseand receive $312 [(78 – 74.88) x $100 = $312].The writer of the option would pay the holder this cash amount.

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Closing TransactionsAs with equity options, an index option writerwishing to close out his position buys a contractwith the same terms in the marketplace. In order toavoid assignment and its inherent obligations, theoption writer must buy this contract before the closeof the market on any given day to avoid notificationof assignment on the next business day. To close outa long position, the purchaser of an index optioncan either sell the contract in the marketplace orexercise it if profitable to do so.

Basic Strategies

The versatility of index options stems from the vari-ety of strategies available to the investor. The mostbasic uses of index options are explained in the fol-lowing examples. These examples are based onhypothetical situations and should only be consid-ered as examples of potential trading approaches.Other strategies that might be used with equityoptions, such as spreads and straddles, can beemployed with index options. For more detailedexplanations, contact your brokerage firm or theexchanges where index options are traded.

Note: For purposes of illustration, commis-sion and transaction costs, tax considerations andthe costs involved in margin accounts have beenomitted from the examples in this booklet. Thesefactors will affect a strategy’s potential outcome, soalways check with your brokerage firm and tax advi-sor before entering into any of these strategies. Forillustrative purposes, the index option positions inall of the following examples are shown to be helduntil expiration. The premiums are intended to bereasonable, but in reality will not necessarily exist ator prior to expiration for a similar option.

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Strategy 1: Buying Index Calls

Long Index Call

Market Outlook: Bullish over the short termGoal: Positioning to profit from an increase in the

level of the underlying index

You are anticipating an advance in the broad marketor market sector measured by the underlying indexin the near future. You want to take an aggressiveposition that can provide a great deal of leverage.This decision is made with the understanding thatthere is a possibility you may lose the entire premi-um you pay for the option.

An index call option gives the purchaser theright to participate in underlying index gains abovea predetermined strike price until the optionexpires. The purchaser of an index call option hasunlimited profit potential tied to the strength ofadvances in the underlying index.

ScenarioAssume the underlying index that interests you issymbolized as XYZ and is currently at a level of200. You decide to purchase a 6-month XYZ 205call for a quoted price of $4.75 per contract. Yournet cost for this call is $475 ($4.75 x 100 multipli-er). You are risking $475 if the underlying index

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+Profit

0

Loss

–

BEP209.75

205

Max Loss

–$475

Index LevelLower Higher

level is not above the strike price of 205 when theXYZ call expires. The break-even point (BEP) atexpiration is an XYZ index level of 209.75 (strikeprice 205 + premium paid $4.75) because the callwill be worth its intrinsic value of $4.75, which iswhat you originally paid for it. The higher the XYZindex settlement value is above the break-even pointat expiration, the greater your profit.

Possible Outcomes at Expiration1. XYZ index level above the break-even

point (209.75):If at expiration XYZ index has advanced to 215, theXYZ 205 call will be worth its intrinsic value of $10(settlement value 215 – strike price 205). Your netprofit in this case would be $525 (settlementamount $1000 received from exercise – net cost ofcall $475).

Buy XYZ Index 205 Call at $4.75 with Index at 200Net Cost for Call = $475Level of XYZ Index XYZ Index XYZ Index XYZ Index Declines to 198 Advances to 207 Advances to 215at expiration (below strike) (between strike (above BEP)

and BEP)Move in level ↓2 pts. ↑7 pts. ↑15 pts.of indexValue of call 0 $2 $10at expiration (out-of-the-(per contract) money)Less premium $4.75 $4.75 $4.75paid for callNet profit/loss* –$475 –$275 +$525(per contract x 100)

*Exclusive of commissions, transaction costs and taxes.

2. XYZ index level between strike price (205) andbreak-even point (209.75):

If at expiration XYZ index has advanced to 207,the XYZ 205 call will be worth its intrinsic value of $2.00 (settlement value 207 – strike price 205).You could exercise the option and receive the set-tlement amount of $200 ($2.00 intrinsic value x100 multiplier). This amount would be less thanthe net amount paid for the call ($475), but it

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would offset some of that cost. The net loss in this case would be $275 (net cost of call$475 – settlement amount $200 received from exercise). This loss represents a little more thanhalf of your initial investment.

3. XYZ index level below strike price (205):If at expiration XYZ index has declined to 198, thecall would have no value because it is out-of-the-money. You will have lost all of your initial invest-ment, a net of $475. The net premium paid for anindex option represents the maximum loss for anoption purchaser. Note: No matter how far XYZdeclines below the strike price, the loss will notexceed $475.

Strategy 2: Buying Index Puts

Long Index Put

Market Outlook: Bearish over the short termGoal: Positioning to profit from a decrease in the

level of the underlying index

You are anticipating a decline in the broad marketor market sector measured by the underlying indexin the near future. You want to take an aggressiveposition that can provide a great deal of leverage.

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+Profit

0

Loss

–

BEP191.10

205

Max Loss

–$390

Index LevelLower Higher

This decision is made with the understanding thatthere is a possibility you may lose the entire premi-um you pay for the option.

An index put option gives the purchaser theright to participate in underlying index declinesbelow a predetermined strike price until the optionexpires. The purchaser of an index put option hassubstantial profit potential tied to the degree ofdeclines in the underlying index.

ScenarioAssume the underlying index that interests you issymbolized as XYZ and is currently at a level of200. You decide to purchase a 6-month XYZ 195put for a quoted price of $3.90 per contract. Yournet cost for this call is $390 ($3.90 x 100 multipli-er). You are risking $390 if the underlying indexlevel is not below the strike price of 195 when theXYZ put expires. The break-even point (BEP) atexpiration is an XYZ index level of 191.10 (strikeprice 195–premium paid $3.90) because the put willbe worth its intrinsic value of $3.90, which is whatyou originally paid for it. The lower the XYZ indexsettlement value is below the break-even point atexpiration, the greater your profit.

Possible Outcomes at Expiration1. XYZ index level below the break-even point

(191.10):If at expiration XYZ index has declined to 185,the XYZ 195 put will be worth its intrinsic value of$10 (strike price 195 – settlement value 185). Yournet profit in this case would be $610 (settlementamount $1000 received from exercise – net cost of put $390).

2. XYZ index level between strike price (195) andbreak-even point (191.10):

If at expiration XYZ index has declined to 193,the XYZ 195 put will be worth its intrinsic value of $2.00 (strike price 195 – settlement value 193). Youcould exercise the option and receive the settlement

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amount of $200 ($2.00 intrinsic value x 100 multi-plier). This amount would be less than the netamount paid for the put ($390), but it would offsetsome of that cost. The net loss in this case would be$190 (net cost of put $390 – settlement amount$200 received from exercise). This loss represents a little less than half of your initial investment.

3. XYZ index level above strike price (195):If at expiration XYZ index has advanced to 202,the put would have no value because it is out-of-the-money. You will have lost all of your initialinvestment, a net of $390. The net premium paidfor an index option represents the maximum loss foran option purchaser. Note: No matter how far XYZadvances above the strike price, the loss will notexceed $390.

Buy XYZ Index 195 Put at $3.90 with Index at 200Net Cost for Put = $390Level of XYZ Index XYZ Index XYZ Index XYZ Index Advances to 202 Declines to 193 Declines to 185at expiration (above strike) (between strike (below BEP)

and BEP)Move in level ↑2 pts. ↓7 pts. ↓15 pts.of indexValue of put at 0 $2 $10expiration (out-of-the-(per contract) money)Less premium $3.90 $3.90 $3.90paid for putNet profit/loss* –$390 –$190 +$610(per contract x 100)

*Exclusive of commissions, transaction costs and taxes.

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Index Options Glossary

American-style option: An option contract thatmay be exercised at any time between the date ofpurchase and the expiration date.

AM settlement: A settlement style in which theexercise settlement values of options are based onthe reported level of the index derived from theopening prices of the component securities on theday of exercise.

Assignment: The receipt of an exercise notice by anindex option writer (seller) that obligates him to pay(in the case of a call or put) the exercise settlementamount for a particular index option if it is exercisedby its holder.

At-the-money: An index option is at-the-money ifthe strike price of the option is equal to the currentlevel of the underlying index.

Broad-based index: An index that measures movesin broad, diverse markets. See Index.

Call: An index option contract that gives the holderthe right to receive, upon exercise of the option, theexercise settlement amount for a fixed period of time.

Capitalization-weighted index: An equity indexconstructed so that more highly capitalized issuesare weighted more heavily than the lesser-capital-ized components. Changes in the stock price ofhighly capitalized issues have a greater impact onthe index’s value.

Capped-style option: A capped option is an optionwith an established profit cap or cap price. The capprice is equal to the option’s strike price plus a capinterval for a call option or the strike price minus acap interval for a put option. A capped option isautomatically exercised when the underlying securi-ty closes at or above (for a call) or at or below (for aput) the option’s cap price.

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Cash settlement: The process by which the termsof an index option contract are fulfilled through thepayment or receipt in dollars of the amount bywhich the option is in-the-money, as opposed todelivering or receiving the underlying instrument.

Class of options: Option contracts of the same type(call or put) and style (American, European orCapped) that cover the same underlying index.

Closing purchase: A transaction in which the pur-chaser’s intention is to reduce or eliminate a shortposition in a given series of options.

Closing sale: A transaction in which the seller’sintention is to reduce or eliminate a long position ina given series of options.

Component securities: Securities whose prices areused to calculate a given index.

Early exercise (or assignment): Exercise of anoption by its holder, or an assignment of an exercisenotice to an option writer, on a day before theoption expires.

Equal dollar-weighted index: An equity indexwhich assigns equivalent influence to each compo-nent stock by representing them in approximateequal-dollar amounts. These indexes are typicallyre-balanced to ensure that the components continueto have equal influence. See Index.

Equity index option: An option whose underlyinginstrument is an index. Generally, index options arecash-settled.

Equity options: Options on shares of an individualcommon stock.

European-style option: An option contract thatmay be exercised only during a specified period oftime just prior to its expiration.

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Exercise cut-off time: A deadline by which aninvestor must notify his brokerage firm, or the brokerage firm to notify OCC of intention to exercise a long option contract. An individualinvestor must adhere to his brokerage firm’s predetermined cut-off time.

Exercise price: See Strike price.

Exercise settlement amount: The differencebetween the exercise price of the option and theexercise settlement value of the index on the day an exercise notice is tendered, multiplied by theindex multiplier.

Exercise settlement value: The price level of an underlying equity index used to calculate theexercise settlement amount.

Expiration date: The day on which an option contract becomes void. All holders of options mustindicate their desire to exercise, if they wish to doso, by this date.

Expiration cut-off time: The time of day by which all exercise notices must be received on theexpiration date. An individual investor must adhereto his brokerage firm’s predetermined cut-off time.

Holder: The purchaser of an option.

Index: A compilation of several stock prices into asingle number used as a benchmark against whichfinancial or economic performance is measured.

Index option: An option contract that has an equity index as its underlying instrument.

In-the-money: An index call option is in-the-money if the strike price is less than the currentlevel of the underlying index. An index put option is in-the-money if the strike price is greater thanthe current level of the underlying index.

Intrinsic value: The amount by which an option is in-the-money (see above definition).

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Long position: A position wherein an investor’sinterest in a particular series of options is as a netholder (i.e., the number of contracts bought exceedsthe number of contracts sold).

Margin requirement (for options): The amount an option investor is required to deposit and main-tain to cover a position as collateral. The marginrequirement is calculated daily.

Narrow-based index: An index that measures spe-cific industry sectors of the marketplace. See Index.

Opening purchase: A transaction in which the pur-chaser’s intention is to create or increase a longposition in a given series of options.

Opening sale: A transaction in which the seller’sintention is to create or increase a short position in a given series of options.

Out-of-the-money: An index call option is out-of-the-money if the strike price is greater than themarket price of the underlying index. A put optionis out-of-the-money if the strike price is less thanthe market price of the underlying index.

PM settlement: A settlement style in which the exercise settlement values of options are basedon the reported level of the index derived from the last reported prices of the component securitiesof the index at the close of market hours on the day of exercise.

Premium: The price of an option contract, as deter-mined in the competitive marketplace, which thebuyer of the option pays to the option writer for the rights conveyed by the option contract.

Put: An index option contract that gives the holderthe right to receive, upon exercise of the option, theexercise settlement amount for a fixed period of time.

Sector: A distinct subset of a market, industry, oreconomy, whose components share similar charac-teristics.

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Series: All option contracts of the same class thatalso have the same unit of trade, expiration date andstrike price.

Short position: A position wherein a person’s inter-est in a particular series of options is as a net writer(i.e., the number of contracts sold exceeds the num-ber of contracts bought).

Strike price: The strike price (or exercise price) of acash-settled option is the base for the determinationof the amount of cash (cash settlement amount), ifany, that the option holder is entitled to receiveupon exercise.

Time value: The portion of the option premiumthat is attributable to the amount of time remaininguntil the expiration of the option contract. Timevalue is the amount of premium in excess of in-trinsic value.

Type: The classification of an option contract aseither a put or a call.

Underlying index: The equity index on which aclass of index options is based.

Volatility: A measure of the fluctuation in the pricelevel of the underlying index. Mathematically, volatil-ity is the annualized standard deviation of returns.

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For More InformationThe American Stock Exchange, L.L.C.An NASD Company86 Trinity PlaceNew York, NY 10006 USA1-800-THE-AMEX(212) 306-1000www.amex.com

Chicago Board Options Exchange, Inc.400 South LaSalle StreetChicago, IL 60605 USA1-877-THE-CBOE(312) 786-5600www.cboe.com

International Securities Exchange L.L.C.60 Broad Street26th FloorNew York, NY 10004 USA(212) 943-2400www.iseoptions.com

Pacific Exchange, Inc.Options Marketing301 Pine StreetSan Francisco, CA 94104 USA1-800-825-5773(415) 393-4028www.pacificex.com

Philadelphia Stock Exchange, Inc.1900 Market StreetPhiladelphia, PA 19103 USA1-800-THE-PHLX(215) 496-5404www.phlx.com

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The Options Clearing Corporation440 South LaSalle Street, Suite 2400Chicago, IL 60605 USA1-800-537-4258(312) 322-6200www.optionsclearing.com

The Options Industry Council1-888-OPTIONSwww.888options.com

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Notes

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