Index Options Fundamentals
An index is a group of securities representing a particular market, or market segment, grouped by similar characteristics. Index options are call or put options to purchase or sell the underlying index in the future at a predetermined price.
A call option gives the purchaser the option to purchase the index at a predetermined price, also known as the strike price, while a put option gives the purchaser of the option contract the privilege of selling the underlying index for a predetermined price.
Both call and put options have an expiration date that they must be exercised on. European index options must be exercised on the expiration date, unlike American options which can be executed any time before the expiration date.
There are many benefits of utilizing index options in an investing strategy. One of the main advantages is the diversification of the investment and having exposure to an entire market or market segment, instead of exposure to a single individual security. This same benefit can also be a drawback to index options as the upside is limited compared to a single security that could have a much higher beta.
Index options give investors the ability to trade an entire market or market segment with significantly less capital and more reward potential. The investor can buy and sell the options and profit on price fluctuations of a stock without ever putting up the money for the security itself. Index options or options as a whole are said to have leverage, meaning the investor makes more per dollar invested.
Also, index options can be used to hedge a portfolio against potential market pullbacks. If a put option is purchased and the price of the underlying index falls, the investor can sell the underlying asset at a predetermined price, instead of the current market price that has declined to.
Index options also have an amount of risk, one of the risks and potential drawbacks to investing using index options is the potential to lose the entire investment if the trader predicts the market move wrong. The entire price of the option contract can be lost if the contract is not sold or executed on or before the expiration date, or value of the option contract could decline if the market starts to trend opposite of the predicted trend.
This time horizon of option contracts could also be a negative to investors who want a long-term investment.
One of the largest indices in the Asia Pacific region and the world is the ASX 200. ASX is the Australian Securities Exchange and the ASX 200 is comprised of the 200 largest traded companies on the Australian Securities Exchange based on market capitalization. The ASX is the 8th largest equity market in the world, with continued growth.
Investors who wish to invest in Australian indices are not limited to just the ASX 200 and also have the ability to invest in other ASX indices such as ASX 100 and ASX 50, both of which like the ASX 200 are weighted based on market capitalization. These indices include large and heavily traded companies like BHP Billiton Ltd, Commonwealth Bank of Australia and Fortescue Metals Group.
Options on the Australian Securities Exchange utilize the European exercise style meaning they have a specified date they must be exercised.
Investing in the Australian market is a wise investing decision based on the economic growth pattern and potential the Australian Securities Exchange provides. Australian Index Options are a great investing resource for anything from hedging an Australian equity portfolio to trading predicted market swings with a smaller amount of capital.
Michael West is a business analyst with a keen interest in stock markets and deriatives. Michael holds a Masters of Business and writes for a number of financial publications.