Another Way to Use the ‘Options’ the Market’s Most-Versatile Tool

If you’ve kicked around the markets a while, you’ll no doubt have come across options. For those that use them, they offer a range of really useful strategies.

For investors who believe a stock price is going to rise, buying a call option gains them exposure to the underlying share price without tying up all their capital. In effect, it buys them time to see if the share price move comes off before committing more of their funds.

And for those who think a stock price could be about to fall, they can buy a put option. The value of a put option increases as a share price falls, thereby allowing a trader to profit from a downward move.

Buying a put option can also be a great way to protect existing shares. It allows the put-option buyer to lock in a selling price in advance should the share price fall, but is not binding. By buying the option, it’s their right to choose whether or not to exercise the option.

And, of course, writing options — that is, selling options — can be a useful way to generate income. It’s one of the strategies we use at Options Trader, my options advisory service.

These strategies are just a few of the dozens available that option traders use every day in the markets over shares. But trading options isn’t just confined to shares.

More ways to use options

What some investors might not be aware of is that the same strategies that can be used over shares can also be applied to the index. That is, the S&P/ASX 200 index, also known as the XJO.

The ASX lists options on the XJO, which allows options traders to speculate on the future direction of the market. Much like buying a call option over a share, an option trader could buy an index call option if they thought the market was heading upwards.

The same logic applies to both shares and the index. The call-option buyer needs to believe that the underlying instrument (whether shares or the index) can realistically reach the option strike price before the option expires.

By buying an index call option instead of a share option, it alleviates one of the tougher things we all find with the market — stock picking. By buying an index call option, you’re backing the overall movement of the market, and not one specific stock.

Just as buying an index call option gains exposure to upward moves in the underlying market, buying an index put option gains exposure to a fall in the market. The put-option buyer doesn’t need to pick a fall in an individual stock. Rather, they’re taking a view (and profit) on the broader market falling.

Some important differences

While the same strategies can be used for both shares and the index, you need to be aware of some differences between the two.

For a start, one of the biggest differences is how the option contracts are settled. With share options, shares need to be handed over, or taken delivery of, if the buyer exercises their option.

As the index itself can’t be handed over (or received), index options are cash-settled on the day of expiry. Index options expire on a different day to share options.

Those that exercise an index option that is in-the-money (has intrinsic value) receive a cash payment into their trading account.

This settlement process also throws up another thing on the ‘must-do’ list. Share options that are one cent or more in-the-money (ITM) at expiry are typically automatically exercised by the broker. In fact, you need to instruct your broker not to exercise an in-the-money share option at expiry.

But index options are different. You need to instruct your broker to exercise an ITM option, otherwise you could miss out on receiving the proceeds from a profitable trade. Some brokers will allow you to select an automatic-exercise option, but the onus lies with you.

Another difference with index options is that the buyer can only exercise their option on the day of the expiry. For those already familiar with options, they’ll know this as a European-style option.

While there are many European-style options available for shares, the majority of share options are American-style. That is, they can be exercised at any time up until expiry.

Yet, just because a European option can only be exercised on the day of expiry, it doesn’t mean you have to hold your option until then. You can close out your position prior to expiry simply by doing the opposite of your original trade.

If you bought a call, then you need to sell the same call option. That is, same strike price and expiry date (and ASX option code) — the same as you would with share options.

Here is an example of XJO options expiring in early February this year. The current value of the index is at the top left (5669 points):


Source: CommSec
[Click to enlarge]

Perhaps the biggest difference between index and share options is how they are quoted, and, in turn, what that represents.

A share option contract is typically for 100 shares in the underlying company, although it can vary. One call option contract, for example, gives the buyer the right to buy 100 shares at the option strike price until expiry.

However, an index option is expressed in points, as you can see in the table above. The strike prices are listed in the middle, and the put and call option premiums (and ASX codes) are quoted on either side.

This leads to another important distinction. The ASX uses something called a ‘multiplier’ to convert the index strike price into dollars.

This multiplier is $10 per point, meaning that the option contract value represents 10 times the size of the actual option strike price. An index option with a 5500 strike price actually has an underlying value of $55,000.

An index option with a 5700 strike price and a premium of 72 points (as per the red box in the table above) equates to a premium of $720, should a call-option buyer want to buy this option.

If you bought this option (please note: this is not a recommendation) and the index is trading at 5850 points at expiry, the option value would be $1,500 (at expiry). That is, 5850–5700, multiplied by $10.

Index-option trading might not be for everyone. But for an investor with a swag of blue-chip shares, buying a put option over the index can help hedge their share portfolio.

Index options can be a great tool for those who’d rather trade the direction of the overall market, rather than the movement of an individual stock.

Regards,

Matt Hibbard,
For Markets and Money


While many investors chase quick fire gains, Matt takes a different view. He is focused on two very clear goals. First: How to generate reliable and consistent income in a low-interest rate world. And second, how you can invest today to build wealth over the next 10–15 years. Matt researches income investments. You can find more of Matt’s work over at Total Income, where he is hunting down the next generation of dividend-paying companies for the future. He is also the editor of Options Trader, where he uses basic options strategies to generate additional streams of income beyond the regular dividend payments. Having worked for himself and with global firms for almost three decades, Matt has traded nearly every asset in existence. But now he is on a very different mission — to help investors generate income irrespective of what the market is doing. It’s about getting companies to pay you a steady, stable income, with minimal stress and the least risk possible. Matt doesn’t believe you have the luxury of being a bull or a bear in the market right now. You have to earn an income from it, regardless of whether stocks are going up or down. By getting the financial markets to pay you an income, you can get to focus on more important things than just money.


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