The Other Multiplier Effect

You switch on the news and see that the market has made a big jump. Excitedly, you log into your broking account only to find, well, not much has happened at all.

Well, not to your shares, anyway.

Some of your stocks have not moved at all. And others? Frustratingly, some are even down a few cents on the day.

Expecting a nice boost to your trading account, instead, your account has barely budged an inch.

No doubt, we have all experienced this kind of situation before. When the market makes a huge move, some shares completely miss out on the action.

It’s the very reason why some investors put stock picking in the too-hard basket. Instead, they place their money in managed funds, including exchange traded funds (ETFs). Someone else can take care of all the hassle.

As you know, ETFs offer a way to gain exposure to the market as a whole.

With an index-based ETF, you don’t have to worry about all the individual swings in the stocks. In doing so, though, you accept that your investment will only generate the overall market return. No more, no less.

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Not what it is about

There are any number of ETFs that replicate the ASX 200, or most indices, for that matter. What’s more, they will charge only a fraction of some fund managers — many of whom won’t even match, let alone beat, the market return.

The strange thing is, the index was never supposed to be something in which to invest. Its aim was simply to help investors gauge the overall movement, and strength, of the market.

When first traded, the index was the province of futures traders. A way to speculate or hedge an existing portfolio.

However, now there are many ways in which an investor can gain exposure to the index.

There is the aforementioned ETFs and index futures, such as the SPI 200. That is, the Share Price Index (SPI) — the futures contract for the ASX 200 index. It also has a ‘mini’ contract for those that don’t want to trade the full contract size (at $25 a point).

There are also CFDs (Contracts For Difference), which enables private investors to trade much smaller contract sizes if they wish. While a single point move in the SPI Mini represents $5, you can trade an index CFD for as little as $1 a point.

There is also another way to trade indices. That is, through options.

While investors are familiar with share options, they might not be aware that they can also trade options on the ASX 200 index.

Like futures, traders use index options to speculate on the future direction of the market, or hedge a portfolio. It’s a way of backing your belief in what the market will do, rather than on just an individual stock. 

On the rise

What investors might be even less familiar with, is, the popularity of index options. If you look at the ASX’s statistics, while share options are still popular, it is index option trading that is really on the rise.

There are many reasons for this. And it comes back to gaining exposure to the market as a whole, versus trying to pick individual shares.

Currently, there are around 60–70 individual stocks on which you can trade options. The ASX 200 options, though, give you exposure to the top 200 stocks all though the one trade.

Trading options on the index might mean that you might miss out directly on a particular stock jumping. But it also means that you are less exposed should an individual share price move against you. That’s because that stock represents just one out of the 200 in the index.

However, index options are a derivative of the underlying index. So don’t forget the large weighting of the banks and finance stocks in the index. The factors that drive the index itself, also drives options on that index.

Whether you trade share or index options, the same strategies apply. Buying a call option gives you exposure to an upward movement in the index price. While buying a put option gives you exposure to a fall in the index.

And like shares, traders also write (initial trade is to sell) index options to generate income. There are, though, some important differences.

Index options are ‘European’, meaning you can only exercise them on the day of their expiry. American options — where you can exercise them any time until they expire — are more common with share options. Although you can trade both styles on most shares.

Another major difference is settlement. Unlike share options, where exercised shares change hands, index options are cash-settled. Meaning money, rather than shares, go into or out of your account. Index options also settle on a different day of the month to share options.

But perhaps the biggest difference is the size (exposure) you are trading. A share option contract is usually for 100 shares. For a stock that trades at around $2, that means an exposure of $200 per contract.

Compare that to index options that use a multiplier of 10. Meaning that a 50-point premium (the ASX uses points to quote index prices) is worth $500 (50 x 10). In other words, you are trading 10 times the size of the underlying index — a much bigger exposure than trading a handful of share options.

For some, that size might simply be too much. That’s the thing about a multiplier — it works both ways. Meaning you always have to fully understand your obligations, especially when you write options.

For fund managers, though, writing index call options can be a great way to boost income beyond the usual dividends.

And for investors and fund managers alike, buying a put option over the index enables them to help protect a share portfolio through a single transaction. Plus, speculate, if they wish, on the future direction of the market, without tying up all their capital.

Regards

Matt Hibbard,
Editor, Markets & 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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