Join our investing community

buying a put option on the index

Discussion in 'Shares' started by crc_error, 15th May, 2008.

  1. crc_error

    crc_error The Rule of 72

    Joined:
    1st May, 2007
    Posts:
    1,367
    Location:
    Melbourne, VIC
    Hi All, Just wondering if someone can explain to me how to purchase a put option on the index?

    Say I want to protect $100,000 worth of stock, what option would I buy, and how do I work out how many I need to protect $100,000 worth?

    The all ords is climbing up quickly, and I'm worried its forming a double top, so I want to hedge my position once it gets back to the peak.
     
  2. Tim

    Tim Well-Known Member

    Joined:
    27th Jun, 2006
    Posts:
    111
    Location:
    Lismore NSW

    While not a put option, one way you could hedge is to exercise a CFD short order against the same long order. That way if you believe in holding for the long term but expect a drop soonish, you can gain on a drop and at worse case scenario breakeven on any gain from when you take out the hedge.


    Tim
     
  3. Rod_WA

    Rod_WA Well-Known Member

    Joined:
    18th May, 2007
    Posts:
    324
    Location:
    Inglewood, WA
    Going short on the index with a CFD has a definite pitfall compared to a put option: the losses grow as your decision is proved more wrong.

    With a put option, you know your maximum loss at the outset, = the premium paid. For a CFD on an index, you will suffer a linear loss if you get the direction wrong.

    Also, for a CFD, you will need to keep putting up margin/collateral to cover the loss, which would be very difficult to handle, even though the underlying portfolio you're protecting is increasing in value.

    Before you consider buying an option, go to the ASX website Understanding Stock Options - Stock Options Advice Australia - ASX and read all about them.

    You can buy an option through any accredited derivatives broker (including many lower cost internet brokers) but you'll need to understand how they work first.

    Options are very curious beasts, and the temptation is to go for the cheap out-of-the-money options. But understand this: professionals leave the ootm options to the mug punters...

    CFD Options??? These days CFD providers also allow you to use 'binaries' or even a layer over the options market, ie you can buy a CFD option. So you don't even have to have an options account with your broker to achieve hedging. But you must understand them first.

    Reiterating: Read everything about options at the ASX website, then call your regular share broker and ask who they recommend for options trading (usually themselves!) And keep in mind the tax outcomes can be significant, including income tax payable on any option gain, potential loss of franking credits ('at risk' holding rule).
     
  4. Tim

    Tim Well-Known Member

    Joined:
    27th Jun, 2006
    Posts:
    111
    Location:
    Lismore NSW
    CRC

    why do you think we are heading towards a double top?

    Tim
     
  5. crc_error

    crc_error The Rule of 72

    Joined:
    1st May, 2007
    Posts:
    1,367
    Location:
    Melbourne, VIC
    have a look at the chart.. the question is, will it break through the previous peak, or bounce off it back down, in what case it will look like a double top.

    I want to hedge myself once its at the peak, so if it does fall, then I'm covered.

    I'm surprised no one here knows how they work.

    There is a option code XJORS which is a June 09 6000 asx 200 put. but I don't know how to work out how many contracts you need to cover X dollar amount.
     
  6. Rod_WA

    Rod_WA Well-Known Member

    Joined:
    18th May, 2007
    Posts:
    324
    Location:
    Inglewood, WA
    For index options, $10 per index point, so one ASX200 6000 contract is 6000 x 10 = $60,000. Index options are European style, which means they are exercised at expiry (not before) and they are settled with cash, rather than an exchange of any shares etc.

    It's all on the ASX website; take it from them, not me.

    For example, with the index at 3400 points
    you buy a March 3400 put option for 60
    points (or $600). At expiry the index has fallen
    to 3100 points. You receive a cash payment
    equal to the difference between 3400 points
    (the insured value) and the level of the index
    at expiry, in this case 3100 points.
    In other words, you receive a cash payment
    of $3000 (300 points x $10 a point). If your
    share portfolio has moved in line with the
    underlying index, then the profits on the put
    option purchase will largely offset the fall in
    value of the portfolio.
    When you decide to buy shares in the stock
    market you are exposed to two types of risks:
    1. Company risk – the risk that the specific
    company you have bought into will
    underperform.
    2. Market risk – the risk that the whole market
    underperforms, including your shares.
    There are a number of ways to protect your
    shares against market risk using index options.
    You can, for example, buy the shares you
    believe in and buy an index put option to
    protect yourself against a fall in the whole
    market. Depending on the amount of risk you
    wish to remain exposed to, you can choose to
    hedge all or only part of your portfolio. Let’s
    assume that it is January, and the broad
    market index is at 3,400. You have a share
    portfolio worth $68,000 which approximately
    tracks the index. You believe that there may
    be a downturn in the market over the next
    three months. As an alternative to selling
    shares, you decide to buy index put options
    to protect your portfolio. As the March 3400
    index put option has a contract value of
    $34,000 (3400 points x $10 per point), you
    are able to protect your $68,000 portfolio by
    buying two contracts, for 80 points each. The
    total cost is $1600 (ignoring transaction costs).
    The March 3400 put gives you the right, but
    not the obligation, to “sell” the index at a level
    of 3400 at expiry in March. Ignoring fees and
    commissions, your break-even point at the
    end of March is 3400 - 80 = 3320.
    At expiry in March, the index has fallen to 3100
    points, and your options have the following value:

    and so on, from UnderstandingOptions.pdf.
     
  7. crc_error

    crc_error The Rule of 72

    Joined:
    1st May, 2007
    Posts:
    1,367
    Location:
    Melbourne, VIC
    thanks for that, thats what I was looking for..

    so I worked out its about 5% to insure your portfolio for 12 months.

    To insure $120,000 worth of stock (via index) it will cost $5660 for 10 months cover.
     
  8. Tim

    Tim Well-Known Member

    Joined:
    27th Jun, 2006
    Posts:
    111
    Location:
    Lismore NSW
    Cyclic,

    it will be interesting to see if we get a double-top. Your post has inspired me to search wikipedia to learn about double tops. I will keep an idea on it.

    Tim