Unlock returns from a rising or falling market using Index Options

Discover index options, why investors trade them and how index options can be used to generate returns from future market movements.

What are Index Options?

Index options are options over an underlying index. They allow investors to take a position based on their outlook of the future view of the index.

For the ASX Options market there is one index option, XJO, an index of the stocks in the S&P/ASX 200. This index is made up of the largest 200 stocks currently listed on the ASX.

XJO settlement pricing

The XJO reference price is the OPIC (Opening Price Index Calculation) price (ASX code: OXJO), which is published shortly after market open on the expiry day of the XJO option. The OPIC is based on the first traded price of each constituent stock in the index on the expiry day. If a constituent stock does not trade on the expiry day, the last traded price from the previous trading day may be used.

XJO expiry style

All XJO options are European exercise style, meaning the options contract can only be exercised on the expiry day. They are also cash settled when they are exercised as there is no physical underlying.

XJO Options vs Equity Options

Below are some of the key differences between XJO and equity option contracts for the ASX Options Market,

	Equity Options	XJO Options
Underlying security	Approved securities	Approved indices
Options premium	Expressed in cents	Expressed in points
Contract size	Usually standardised at 100 underlying shares (subject to adjustments)	Dollar multiplier per point (usually $10 per index point)
Settlement	Deliverable	Cash settled
Settlement price	Closing price of underlying on expiry day	Opening Price Index Calculation (OPIC)
Exercise price	Expressing in dollars and cents	Expressed in points

Why trade XJO Options

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


Cost effective	Gain exposure to most of Australia’s largest listed companies through one single trade by buying a XJO call option
Portfolio protection	By taking (buying) an XJO put option an investor can protect their share portfolio from a falling market without adjusting their holdings. This protective position may allow an investor to reduce the overall market risk for their share portfolio.
Diversification	Benefit from the instant diversification received from buying an XJO call option over the S&P/ASX 200 index, which covers the 200 largest listed Australian companies.
Leverage	Potential to make a higher return from a smaller initial outlay than investing directly.
Profit from your view	An investor can profit if their view of the future market movements proves correct. An investor has the potential to profit in rising, falling and flat markets, using a range of strategies with varying levels of risk.

Buying a XJO Option

An investor can buy (long) a XJO option contract, either call or put, depending on their outlook on the market (whether they think the S&P/ASX 200 index will rise or fall).

In return for paying a premium for buying the call or put index option, the taker (buyer) then has the right to receive a cash settlement for the index price when it expires above the strike price for a call option, or when the index price is below the strike price for a put option (also referred to as in-the- money).

The maximum loss when buying an index option is limited to the premium paid.

Calculating premium

For index options, the total premium per contract is calculated by multiplying the points per contract by the multiplier of $10 per point, as per the below,

25 points per contract x $10 multiplier = $250 per contract

Calculating cash settlement

By purchasing an index option, the investor could receive a cash settlement if the market moves in their favour in reference to whether it is a call or put option and the chosen strike price of the option.

When a long index option position finishes in-the-money, the cash settlement amount received by the investor is calculated as per the below,

XJO Call Option Cash settlement = (OPIC - XJO Call strike price) x number of contracts x $10 multiplier

XJO Put Option Cash settlement = (XJO Put strike price - OPIC) x number of contracts x $10 multiplier

Closing a bought XJO option position

It is important for an investor to be aware that if the desired market movement occurs prior to expiry, they can realise the returns by ‘selling to close’ the bought position.

By closing the position prior to expiry, the investor will receive some of the purchased time value back and do not risk the market turning against them. The investor will place a sell trade for the bought position in the market and will receive a credit for the trade once it executes.

An investor can close an open options position at any time after opening the position.

Why investors purchase XJO options

There are generally four main objectives investors have when they purchase an index option:


Profit from speculation	Investors may be anticipating a strong upwards or downwards movement in the market.
Diversification & exposure	Investors may be seeking to gain the benefits of diversification through exposure to a diverse mix of companies in the underlying index.
Uncapped gains while limiting losses	Opportunity to make uncapped gains whilst losses are limited to the premium paid to purchase the index option.
Portfolio protection	An investor can use a bought index option to protect their portfolio from a falling market.

Understanding the risks

Movements in the underlying index (for example, the S&P/ASX 200) will generally change the price of the related index option. The underlying index can rise or fall depending on several factors, and the investors’ outlook on the index at the time of buying an index option may differ to when the option is due to expire.

While the potential risks from unfavourable market movements is capped, the investor may lose the entire premium paid for the XJO option.

Both equity and index options have an expiry date and therefore a limited life. An option’s value erodes over its life (known as time decay) which accelerates as the option nears expiry. A loss can still incurred even if the XJO moves in the favour of the bought position e.g., due to time value decay.

Generate returns from a rising market

The below hypothetical example shows how this can work for an investor

The XYZ index is currently trading around 5600, and the investor expects the XYZ to make large gains in the next two months and wants to have the ability to profit from this view.

The investor establishes the below position,

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

The total premium paid by the investor is:

80 points per contract x 10 contracts x $10 multiplier = $8,000 premium

Closing the position prior to expiry date

One month later, the XYZ has risen to 5900 and the position is trading at 235 points. The investor wishes to take these gains prior to expiry.

The investor then sells to close this bought position for the below:

235 points per contract x 10 contracts x $10 multiplier = $23,500 premium

The total profit for the investor is,

Profit = premium received – premium paid = $23,500 - $8,000 = $15,500

Allowing to cash settle

At expiry the XYZ settlement price, or the OPIC price, is 5850. The investor then receives the below cash settlement:

Cash settlement = (5850 – 5700) x 10 contracts x $10 multiplier = $15,000 cash settlement

The total profit for the investor is,

Profit = cash settlement – premium paid = $15,000 - $8,000 = $7,000

Allowing to expire

At expiry the XYZ settlement price, or the OPIC price, is 5650, meaning the index did not make the intended gain the investor expected.

The investor will not receive a cash settlement here as the index option has finished out-of-the-money. As it is a call option this means the settlement (OPIC) price for the index option is below the strike price of the call option.

Total loss = premium paid = $8,000.00

Generate returns from a falling market

The below hypothetical example shows how this can work for an investor:

The XYZ index is currently trading around 5600, and the investor sees the XYZ falling in the next two months and wants to have the ability to profit from this view.

The investor establishes the below position,

Buy 10 XYZ 5500 put option for an expiry in 2 months’ time for 70 points

The total premium paid by the investor is:

70 points per contract x 10 contracts x $10 multiplier = $7,000 premium

Closing the position prior to expiry date

One month later, the XJO sinks to 5300 and the position is trading at 228 points. The investor wishes to take these gains prior to expiry.

The investor then sells to close this bought position for the below:

228 points per contract x 10 contracts x $10 multiplier = $22,800 premium

The total profit for the investor is,

Profit = premium received – premium paid =$22,800 - $7,000 = $15,800

Allowing to cash settle

At expiry the XYZ settlement price, or the OPIC price, is 5350. The investor then receives the below cash settlement:

Cash settlement = (5500 – 5350) x 10 contracts x $10 multiplier = $15,000 cash settlement

The total profit for the investor is,

Profit = cash settlement – premium paid = $15,000 - $7,000 = $8,000

Allowing to expire

At expiry the XYZ settlement price, or the OPIC price, is 5650, meaning the index did not make the intended drop the investor expected.

The investor will not receive a cash settlement here as the index option has finished out-of-the-money. As it is a put option this means the settlement (OPIC) price for the index option is above the strike price of the put option.