A: Index put options give you the right, but not the obligation, to effectively “sell” the market at the designated strike price. Buying a put option is essentially a defensive or bearish strategy – if the market falls below the strike price, you win. If it doesn’t, you will lose the premium you invest.

 

Michael talked about buying 6650 June put options for a price of 115 points. Effectively, you can insure against any fall in the market below 6650 (the level of the S&P ASX 200) for 115 points (the premium).

 

So, if you buy the option and the market falls to 6000, you would make 650 points, less the premium of 115 points. If the market stays above 6650 and you never exercise the option, you lose your premium of 115 points.

 

Each option has a multiplier of $10 – so 1 index point is worth $10, 115 index points (in this case the premium) is worth $1,150. If the market falls to 6000, your option would be worth (on exercise) $6,650. To insure a portfolio of $1,000,000 value, you would need to buy $1,000,000/6650/10 – approx. 15 option contracts.

 

Important things to remember about index options are:

1. The protection is time limited. The option has an expiry date (in this case, the 3^rd Thursday in June), and if never exercised, it will expire worthless;
2. These options are cash settled. They are not over the stocks that make up your portfolio – rather, the market index;
3. They are European – which means that they can only be exercised on the expiry date;
4. The price (premium) will change as the market moves, as the option gets closer to expiry (less time value), and according to volatility swings in the market.

 

You can invest in index options with most of the major brokers, and some online brokers such as CommSec. You will need to open a separate options trading account.