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How people trade index options?

Writer's picture: Matthew CW WongMatthew CW Wong

HKEx listed Index options


Earning premium and sell options. Many option traders like selling options to receive a premium, and collect time decay. They bet on the underlying index not moving below the strikes of the puts they sold and not moving above the strikes of the calls they sold. For example, today is 6 June 2022, Hang Seng Index is at 21,000, Jun expiry 21000 call is at 520.

If a trader sells 10 calls at 520, the trader will earn a maximum profit if, on 29 June, the option expiry day, the index expiry setting is at 21000 or below. The trader will profit 10 calls x 520 points x HKD 50 = HKD 260,000. If the index expiry setting is at 22000, the trader will have a loss of 10 calls x (1000-520)points x HKD 50 = HKD 240,000. In the case of selling options, the maximum gain is the option premium received and the loss could be unlimited.


To limit potential loss, the trader could buy call options at a higher strike price to build short call spread positions. For example, when selling 10 Jun 21000 calls at 520, also buy 10 Jun 21600 calls at 275. If the index expiry setting is at 22000, the loss would be the HKD 240,000 loss from the Jun 21000 calls less the gain from the 10 21600 calls that is 10 calls x (400-275) points x HKD 50 = HKD 62,500. The total loss becomes HKD 177,500. If the index expiry setting is at 21000 or below, the profit would be 10 call spreads x (520-275) points x HKD 50 = HKD 122,500.


Options near expiry, say, 1 day before expiry behaves like a digital option with a 1 or 0 outcome. Liquidity could be limited. Implied volatility also becomes less meaningful to options with a few days left as the Option Pricing model starts to be less applicable. The assumption of normal distribution in share price movement does not have enough readings left to justify it. The delta hedging strategy becomes harder to implement smoothly as stock price movement is not continuous.


Professional Option traders will dynamically hedge their positions to adjust the risk profile. Typically measured by delta (market direction), gamma (change of delta with respect to underlying movement), vega (volatility changes), theta (time decay in option prices), rho (interest-rate sensitivity), psi (dividend sensitivity).


When trading options, especially with short option positions, a trader needs to beware of margin requirements. Besides the initial margin, there is a variable margin that is subject to market movement. When the underlying, index futures, moves against the positions, the trader will be likely to top up the margin as reflected by the increase in mark-to-market losses. When the market is volatile, the exchange could also increase margin requirement on top of the mark to market losses. In case of failing to top up the margin in time, the broker may need to force liquidate part or all of the positions to fulfil Exchange requirements.


In this article, we use the cash-settled call and put options on Hang Seng Index as a reference. They are European options. Cash-settled based on the same index futures expiry cash-settled mechanism. HKEx launched physically settled index options on index futures in 2021 that I am not referring to here. However, the trading strategies and risk are similar on most indices globally.


Ref: Hang Seng Index Options (hkex.com.hk)


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