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Index options have arrived!

Index options are now one of the ten most popular option contracts traded on the Australian market. Despite being hugely popular on overseas markets Index options have been slow to catch on in Australia, until now. These options are now gaining wide acceptance with investors as shown by the 76,000 contracts traded in September. Many investors may be wondering, what's the appeal?

In this article we look at the increase in popularity of Index options and the benefits they offer investors.

Index options allow you to speculate on your overall sense of market direction, degree of change, and timing of change to profit on swings in the market. Also they can be used as a hedge against losses.

Index options, like all options, provide you with opportunities to either speculate or insure a portfolio. Index options are available in either call form (rise in value as the index rises) or put form (rise in value as the index falls). An example of insuring your portfolio could occur if you had $100k invested in shares. Buying one index option at 3200 points equates to insuring $32,000 of stock. A 3200 put option therefore protects about 1/3 of a $100k portfolio. If you want greater protection, then you may simply buy more contracts.

Unlike exchange traded options, which enable you to buy and sell company shares, index options still offer insurance benefits but settle in cash rather than in shares. You receive or pay the difference between the strike price that you traded and the underlying index value on expiry. For example, if you bought an XJO (which tracks the S&P/ASX200) Sep 3000 call and the index closes at 3200 on expiry, the option is cash settled for $2000.

As with all options trading at ASX, collateral other than cash is acceptable to cover margin requirements. Shares, instalment warrants and certain interest rate securities that might otherwise be sitting dormant can be put to good use as security for other possible investments. The full list of eligible collateral is available on the ASX website.

Many investors have used covered call writing to both generate extra income and provide downside protection. This can be a labour intensive task as your portfolio grows. One solution is to replace the selling of each stock option with one index option. The advantages are ease of transaction; one trade instead of many, no likelihood of being exercised early, and as index options are cash settled, you don't have to sell your stock if the options are assigned.

Index options are just like equity options and you can use the same strategies and techniques including spreads and straddles and combinations. Of course, as with equity options, you can close out your option at any time before expiry. For advice on whether index options suit your financial circumstances, please talk to your broker or financial adviser.

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