Why trade XJO Options

Investors trade XJO options, either by buying or selling, to potentially take advantage of some of the following features:

Source: CommSec

Understand the risks

The risks of trading index options will vary depending on the strategy being used. 

• The price of an index option can rise or fall, depending on changes in the underlying index. The index’s outlook at the time of buying/selling an index option may be completely different to the outlook when the option is due to expire.
• When you buy an index option, you could lose the entire value of the premium you have paid.
• Selling (or writing) index options involves significant risks, and losses are potentially unlimited. Sold index options have a very different risk profile to bought index options, and it is vital to understand the risks attached to this strategy before implementing. This article does not cover that strategy.
• Index options have an expiry date and therefore a limited life. The value of the option erodes over its life (known as time decay), and this accelerates as the option nears expiry.

Investors should ensure they understand all the risks associated with an index option strategy before trading them. 
 

1. Profit from a rising market

Buying an index call option allows an investor to gain exposure to an increase in the underlying index.

The below hypothetical examples show how this can work for an investor:

The XYZ index is trading around 5600. An investor expects the XYZ to jump in the next two months, so they enter the below position:

Buy 10 XYZ 5700 call option for an expiry in 2 months’ time for 80 points.

The total premium paid is:

= 80 points per contract x 10 contracts x $10 multiplier

= $8,000 premium

After entering the position, the investor can:

• Close (sell) the position prior to expiry – if the expected movement in the XYZ index occurs before the expiry date, or to minimise losses and recoup time value.
• Allow the position to expire – either for a cash settlement, or as worthless.

The breakeven point at expiry (the point where the investor neither makes nor loses money) is the exercise price (strike price) plus the premium paid. This means that if the XYZ is above 5780 at expiry, the investor will make a profit. However, if the XYZ is below 5780 at expiry, the investor will make a loss.

Outcome 1 – XYZ index rises to 5800 by expiry

If the XYZ index rises to 5800 at expiry, then the bought index call option is 100 points in-the-money. For a call option, “in-the-money" refers to when the underlying price is above the exercise price. The amount the exercise price is above the underlying price is known as the intrinsic value.

Here a 3.6% increase in the index has meant a 25% increase in the value of the call option.

The cash settlement amount to the investor will be:

= (5800 – 5700) x 10 contracts x $10 multiplier

= $10,000 cash settlement

Making the investor’s profit:

= $10,000 cash settlement - $8,000 premium paid

= $2,000 profit

If this movement occurred before the expiry, the investor could sell the option to realise the gain, plus any remaining time value.

Outcome 2 – XYZ index falls to 5500 by expiry

If the XYZ index falls to 5500 at expiry, then the bought call option is worthless. The option has no intrinsic value (as the exercise price is below the underlying price) and the investor will lose the entire $8,000 premium they paid.

2. Protecting a diversified portfolio

In this hypothetical example, an investor has a diversified share portfolio and is concerned about a potential sharemarket correction. To limit their potential losses, they buy an index put option to hedge their portfolio, as they do not want to sell their shares.

Unlike a protective put strategy with equity options, where the investor would need to purchase a put option for each share they hold in their portfolio, the investor could purchase a single index put option to protect their whole portfolio from a fall.

It is important to be aware of the tracking risk that is attached to this strategy. The success of using index put options to protect a portfolio will depend on how closely the portfolio tracks the relevant index.

The below hypothetical examples show how this can work for an investor:

An investor has a diversified portfolio worth $500,000. The corresponding market index, the XYZ, is currently at 6500 points.

The investor decides to purchase the below position:

Buy XYZ 6500 put option for an expiry in 4 months’ time for 100 points

To hedge their entire share portfolio the investor will need to purchase the below number of contracts:

= Value of share portfolio ÷ Exercise price of index put option

= $500,000 ÷ (6500 x $10 multiplier)

= 8 contracts

So, the total premium paid by the investor is:

= 100 points per contract x 8 contracts x $10 multiplier

= $8,000 premium

Outcome 1 – XYZ index falls to 5850 on expiry

The XYZ has fallen 10% by the expiry date, and the investor’s portfolio is now worth $450,000, a decrease of $50,000.

The bought index put option has 650 points of intrinsic value, so the investor will receive the below cash settlement:

= (6500 – 5850 = 650) x 8 contracts x $10 multiplier

= $52,000 cash settlement

Due to the put option protection, the investor has limited their net losses to $6,000, as the loss in portfolio value exceeds the gain made on the put option, as the table below shows. The investor could also sell the index option prior to expiry to realise a gain in time value.

Source: CommSec

Outcome 2 – XYZ index rises to 6825 by expiry

If the expected downturn did not occur and the market lifted 5%, the investor’s portfolio would now be worth $525,000.

The bought index put option has no intrinsic value and expires worthless.

Although the investor loses the $8,000 premium they paid, their net position is positive $17,000.

Source: CommSec

Conclusion

In 2024, we witnessed heightened turbulence in the global equities market alongside some remarkable new all-time highs.

The ability to understand and use index options can potentially be a valuable tool for investors. Whether investors are looking to capitalise on market swings, protect their portfolio from a potential market correction, or create an additional source of income, index options are a tool to potentially help them achieve their investing goals.