There’s More to Options than Shares

There’s More to Options than Shares

If you’ve taken a look at options before, chances are it’s only been in relation to shares. That’s not surprising. Most of the available information concentrates on them.

But what many investors are less familiar with is that you can trade options on other things as well. You can trade options on currencies and commodities, as well as indices.

While currencies and commodities might not be on everyone’s radar, the index is something we’re more familiar with. Because the index helps us gauge the performance of the market, we see it quoted every day.

However, what is unknown to many is that the index, the XJO, is one of the most highly-traded options on the ASX. And its popularity is growing.

Just like share options, the same strategies apply to index options. You can buy a call option if you think the index is going to rally. And a put option if you think it’s about to fall.

Same strategies, different features

While the strategies overlap, there are differences in how the ASX quotes the strike prices. With share options, you quote the strike price in dollars.

For example, if you buy a call option with a $5 strike price, you have the right to buy the underlying shares at $5 anytime until the option expires.

However, an index option is different — you quote points instead. A 6000 call option gives the buyer the right to buy the index at 6000.

Straight away, you’ll be wondering how someone can buy the index. After all, there are 200 shares included in the index.

But again, this is where index options are different. With share options, you settle a trade with shares. However, with index options, you settle the trade with cash. If an index call option buyer exercises their option, it just isn’t practical for the option writer to hand over all those shares.

Another difference is that index options use something called a multiplier. The multiplier converts the index into a dollar amount.

While a share option is usually for 100 shares, an option contract is worth $10 a point. You work out the face value of an index option by multiplying the strike price by 10. An index option with a strike price of 5500 has a face value of $55,000.

You use the same multiplier to work out the premium. A trader who buys a call option for 45 points will pay $450 in premium (45 multiplied by 10).

Another big difference is the style of options. You can exercise an American-style option anytime until the option expires. However, you can only exercise a European-style option on the day of expiry.

You’ll see both styles of options with shares, although American-style options are much more common. However, index options are typically only European-style.

But how does a trade play out?

Let’s say you buy an index call option with a strike price of 5750, for 50 points ($500 premium). The index would need to be trading above 5800 at expiry for you to make any money. That is, the option strike price of 5750; you also have to recoup the premium (50 points) as well.

In this example, 5800 is your breakeven level. Just like buying a call option on shares, you need to believe that the index will rise above the breakeven by expiry. Otherwise, there’s no point in placing the trade.

But another crucial thing you need to know is about exercise. With share options, most brokers will exercise any options that are one cent (or more) in-the-money (ITM) at expiry. For example, they’ll exercise a $5 call option if the share price is trading at $5.01, or higher.

With index options, this doesn’t happen. Even if an index option is in-the-money (ITM), you have to tell the broker to exercise it. Otherwise, they don’t do it. You need to instruct them if you want them to automatically exercise all ITM options at expiry.

By forgetting to tell them to exercise your option, you could miss out on a profit if your index option expires ITM.

Why are index options so popular? There are a number of reasons. Much like share options, it gives traders the ability to leverage their positions. And if they buy an index option, the most they risk is the premium they pay.

It also takes away the risk of picking individual shares. Rather than picking one share (or a basket of shares), a trader can instead take a view on the general direction of the market.

But another reason is that index options can help hedge your share portfolio. While it doesn’t protect individual shares directly, index put options will increase in value should the market take a fall.

Matt Hibbard,
For Markets & Money

Matt Hibbard

Matt Hibbard

Matt Hibbard is Port Phillip Publishing’s income specialist. While most investors focus on making money in the short term, Matt takes a different view. He’s focussed on how you can invest today to grow wealthy in 10 or 15 years’ time. You can find more of Matt’s work over at Total Income where he’s hunting down the next generation of companies that could pay you more each year than you initially invest.

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