The term index call refers to an investment strategy involving the purchase of a call on a broad market or industry index. Investors purchase index calls if they believe the market or sector is on the rise and they want to take advantage of the leverage provided by a call option.
ExplanationAn index call allows an investor to profit from an increase in an index while limiting the amount of capital at risk. A call option gives the owner the right, but not an obligation, to purchase the underlying index at the strike price before the contract expires. American options may be exercised at any time before expiration, while European options may be exercised on the last day before expiration. That being said, index options may have value and can be traded before expiring. The profit potential for a long call is theoretically unlimited. The risk associated with the call is limited to the premium paid on the option.
Index ABC is currently at $1,000 and the investor can buy a three-month ABC 1,010 call for $22.00. The total cost of the call is $22.00 x 100 (multiplier), or $2,200. The value of the underlying asset would be $1,000 x 100, or $100,000. The investor makes this purchase when they believe Index ABC will increase beyond the breakeven point, calculated as:
= Strike Price of Index + Option Premium= $1,010 + $22, or $1,032
In this example, there are two possible outcomes at expiration:
Index Price Does Not Reach Strike Price
If Index ABC trades below $1,010.00 per share, the contract would expire out-of-the-money. The investor would not exercise their right to purchase the index and they would incur a loss equal to the premium paid on the contract, or $2,200.
Index Price Rises Above the Strike Price
If Index ABC trades above the strike price, the contract is in-the-money and settlement can be used to recoup all, or part of the premium. If the strike price rises above the breakeven point of $1,032, the investor would profit on this position. For example, if Index ABC rises to $1,050, the investor would receive:
= Settlement Amount - Option Premium, or= Index Price - Strike Price - Option Premium, or= $1,050 - $1,010 - $22, or= $40 - $22, or $18
In the above example, the investor would make a profit of $18 x 100 (multiplier), or $1,800.