Turn your market outlook into potential income

In our previous article 'Unlock returns from a rising or falling market using Index Options', we introduced index options and explored how buying-to-open XJO options can be used to generate returns.

In this article we will delve into selling-to-open index options, also referred to as an investor being ‘short’ an index option. We will learn how investors can sell these on the market to generate additional income and the associated risks of this strategy.

This is a strategy available to investors who have a Level 3 or 4 CommSec Options account. Please note Level 3 CommSec Options accounts only allows an investor to sell uncovered call options.

Selling a view on the market

When an investor expects the whole market to trend in a certain direction or to stay within a certain level, they can profit from this with no initial outlay of premium through selling-to-open an index option.

There is always the risk the market can move unfavourably, and if the move is large enough losses may be substantial. Investors do have the ability to protect a short index option position and this will be discussed in our next article.

By an investor selling (or writing) an index option, which they have not previously bought, it is referred to as being short in that options position. The investor will receive the premium for selling the index option in return for accepting the risk of the short position.

The basics

An option is a standardised contract between two parties to buy or sell an underlying instrument, such as a share or index, at a predetermined price on or before a set date.

There are two types of Options:

Call Option	This gives the taker the right, but not the obligation, to buy the underlying security at the predetermined price on or before a set date.
Put Option	This gives the taker the right, but not the obligation, to sell the underlying security at the predetermined price on or before a set date.

When an investor sells (writes) an option, the obligations will vary depending on whether it is a call or a put option, as per the below:

	Call Option	Put Option
Writer	Writers have the obligation to deliver/sell the underlying security	Writers have the obligation to buy the underlying security

As an index option is cash settled, the writer of an index option is obligated to provide a payment to the taker of the index option if the position is exercised.

Index option positions can only be exercised on the expiry day as they all have a European expiry style.

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.

The cash settlement amount for an in-the-money XJO index option is calculated as per the below:

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

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

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.

Why sell an index option

An investor can generate additional income through selling an index option, whether they sell a call or put index option will determine what their view of the upcoming market movement is.

The table below shows possible strategies an investor may take, depending on their market outlook,

Market outlook	Strategy
Market will rise	Sell-to-open put option
Market will be stable	Sell-to-open put or call option
Market will fall	Sell-to-open call option

To generate income, the investor’s goal is for the sold index option to expire out-of-the-money, making it worthless. In this scenario the investor will retain the full premium they received for selling the position.

The below logic is used to determine whether an option position is in-the-money, at-the-money, or out-of-the-money.

	if strike less than the share price	if strike equals the share price	if strike higher than the share price
A Call Option is…	In-the-money	At-the-money	Out-of-the-money
A Put Option is…	Out-of-the-money	At-the-money	In-the-money

Choosing the index option

When an investor sells an index option there are a few factors they must consider before choosing the most suitable strike price and expiry day for their risk reward profile.

These factors include:

Time Value

The expiry day which is chosen will have a great impact on the premium value of the index option.

Option premiums are made up of two components: intrinsic value, and time value.

Option premium = Time value + Intrinsic Value

Time Value	The amount a trader is willing to pay for the possibility that the market will move in their favour before the expiry date. Generally, time value rapidly falls as the Option approaches expiry.
Intrinsic Value	The difference between the Option’s strike price and the market price of the underlying security.

Time value in options pricing is based on the expected volatility of the underlying’s price and the time until the expiry day of the option.

This means the longer the amount of time until the expiry day, the more time there is for the market to move and the more time for the options contract to become in-the-money. On the other hand, the more time for the options contract to become out-of-the-money.

By selling an index option with a longer dated expiry day with the same strike price, an investor will generally receive a higher premium due to the higher time value. Although the higher premium increases the investor’s risk, as the longer dated expiry increases the likelihood of unwanted movements in the underlying index.

Strike price

The strike price of the sold call or put option will affect the premium received from selling the index option.

In-the-money options will have a higher premium, however, will require a larger move in the market to become out-of-the-money. Whilst at-the-money and out-of-money options will have a lower premium as they have no intrinsic value and less chance of expiring in-the-money at the time of entering into the strategy.

Investors needs to establish what time-period they are comfortable holding the sold call or put over, as well as consider the risk the position carries due to the strike price of the position.

Volatility

The premium of an index option will generally fluctuate with movements in the underlying index. Investors needs to be aware that as volatility increases, the premium of both call and put options, at all strike prices, tends to rise.

Investors may consider selling an option in a period of high volatility (to take advantage of higher premiums) if they expect volatility to decrease. However, relying on volatility to achieve a higher premium is generally considered to be a risky strategy, as unfavourable market movements in periods of high volatility could lead to uncapped losses.

The risks

The risks of selling index options are very high, as the potential losses can be unlimited.

When selling an index call option, the potential losses are unlimited, as there is no cap on how high the underlying index level can rise.

For short index put options, the potential losses are inherently capped, as the underlying index cannot fall below zero, however this can still mean an investor is vulnerable to large losses.

When an investor sells a call or put option, they will incur a margin requirement to ensure they are able to cover these losses if they do materialise. The only case where there is no margin requirement for selling an option is when an investor sells a covered call (this is discussed in our previous article ‘Supercharge the income stream from your portfolio’).

It is also important to remember that the underlying index can rise or fall depending on a number of factors, and the index’s outlook at the time of selling an index option may be very different to when the option is due to expire.

Margin requirements

There are margin requirements for when an investor sells an index options position. Margin requirements are imposed to ensure that investors can meet obligations which can arise from a sold call or put option.

For the ASX Options Market, margin obligations are calculated at the end of each trading day with investors required to meet that obligation by 2pm the coming trading day.

Margin obligations will change each trading day and it is essential for investors to meet the updated requirement each trading day.

Margin obligations can be met through cash and/or acceptable collateral. ASX Clear decides what securities are eligible to be lodged as collateral for margin obligation. When collateral is lodged to ASX Clear for margin obligations, there will be haircut on the market value of the security. The haircut varies for each security, but it always reduces the market value of the security lodged by a set percentage.

The list of ASX Clear acceptable collateral and the respective haircut can be found here.

Investors can calculate margin requirements using the ASX Margin Calculator and learn more about ASX margin requirements by reading the ASX Understanding Margins booklet.

Please note CommSec has an additional risk buffer on top of the ASX margin requirement:

Total Margin = ASX Margin + CommSec Margin

Stress testing

CommSec conducts stress tests on all Option portfolios each trading day to assess the impact of changes in market conditions on your portfolio.

Where CommSec identifies a portfolio is unable to support the performance of a simulated market event, the investor will incur a ‘Stress Test Obligation’ for that portfolio.

A Stress Test Obligation is where the investor is required to take action to restore a CommSec portfolio to a level where it can support the simulated event(s).

In practice

The below examples are hypothetical only and are not related to any existing underlying security. Additionally, they do not take into account brokerage and any other fees.

Generating income from a moderately bearish market outlook

An investor has a moderately bearish outlook on the market over the next three months, expecting the market drop around 100 points. As a result, they want the potential to unlock additional income based on this view.

The XYZ market index is sitting at 6400 thus the investor enters the following position:

Sell 10 XYZ 6500 call option for an expiry in 3 months’ time for 113 points

The investor has sold an out-of-the-money call option as they only have a moderately bearish outlook.

By choosing a strike price of 6500 the short call position will expire worthless if the index (OPIC price) finishes below this strike price.

The chosen expiry date is three months out to ensure they are receiving the most time value for the sold call option and this matches their expectation of the potentially declining market.

The maximum gain the investor can achieve is the premium received for selling this call option:

113 points per contract x 10 contracts x $10 multiplier = $11,300 premium

XYZ OPIC closes at 6250 on the expiry day

The market has moved in favour of the investors position, and the OPIC price of the underlying index has finished below the strike price of the call option sold.

The investor retains the full premium received for selling the call option. This is the best-case scenario as the investor is making the maximum profit possible:

Profit = premium received = $11,300

XYZ OPIC closes at 6550 on the expiry day

The market has not moved in favour of the investors position, and the OPIC price of the underlying index has finished slightly above the strike price of the call option sold.

This means the investor is obligated to pay a cash settlement for the amount the call option is in-the-money:

Cash settlement = (6550 – 6500) x 10 contracts x $10 multiplier = $5,000 cash settlement

Although the investor is obligated to pay a cash settlement as the call option expired in-the-money, this cash settlement will be offset by the premium received for initially sell the position.

In this case the investor will still make a profit:

Profit = premium received – cash settlement paid = $11,300 – $5,000 = $6,300

XYZ OPIC closes at 6800 on the expiry day

The market has not moved in favour of the investors position, and the OPIC price of the underlying index has finished far above the strike price of the call option sold.

This means the investor is obligated to pay a cash settlement for the amount the call option is in-the-money:

Cash settlement = (6800 – 6500) x 10 contracts x $10 multiplier = $30,000 cash settlement

The cash settlement the investor is obligated to pay will be offset by the premium received for initially selling the position.

As the cash settlement is greater than the premium received the investor will still incur a loss:

Loss = cash settlement paid – premium received = $30,000 – $11,300 = $18,700

Closing position prior to expiry

It is important that an investor knows when to close out an options strategy prior to the expiry day.

During the life of the strategy if the investor no longer expects for there to be a 100-point drop in the XYZ index, and there is potential for a rise they may look to close out the short call position to reduce the risk.

A month into the strategy the XYZ has rallied up to 6500 and the investor wants to close the short call position to limit their losses.

The investor then proceeds to buy-to-close the XYZ short call position.

The cost of the trade is:

Cost to close = 119 points per contract x 10 contracts x $10 multiplier = $11,900 premium

As the investor pays a higher premium to close the position than what they received to open the short call position, the investor makes a loss:

Loss = premium paid – premium received = $11,900 – $11,300 = $600