The Hang Seng Index (HSI) is an index of the top 50 companies listed on the Hong Kong Stock Exchange. The HSI options are one of Asia’s most liquid equity options, traded over-the-counter (OTC). An HSI index option contract, as its name implies, gives the holder the right to buy or sell a certain number of shares in the form of contracts defined by the particular options series. The cash settlement is based on the current market prices of those underlying stocks at expiry.

The most common index option is the “Hang Seng Index Non-Deliverable Forward (NDF)” option. It has a cash settlement based on the HSI NDF futures price. The NDF does not require owning or delivering any stock; instead, it uses a cash settlement mechanism, enabling investors to receive cash credit instead of actual stocks at expiration. For example, an investor who owns one lot of Hang Seng Index NDF options at HKD475 with a strike price set at 2400 can sell his position today and get paid HKD5250 by exercise date. In addition, the investor only needs to pay brokerage fees for selling the position.

Intrinsic value

Index options have intrinsic value, which is the difference between the current market price and the strike price of underlying stocks. In general, as time elapses toward expiration, index options will increase in intrinsic value. The more time left before expiration, the higher the chance it will move closer to or above its strike price.

NDF contracts do not have any intrinsic value because they are cash-settled based on a predetermined future HSI price at expiry. They trade flat most of the time but will show a profit/loss from time to time due to volatility changes in those underlying stocks.

Interest rate

As the interest rate in Hong Kong is very low, index options with a relatively long time to expiration may be cheaper than NDFs. Therefore, it is better to have the intrinsic value of an index option grow over time, thus increasing its premium value.

NDFs are usually traded OTC, so there is no interbank lending involved. You can obtain credit from a primary dealer at a 0% borrowing cost if needed, and overnight rates will apply.

Margin requirements for contracts

Index option contracts require margin when they are opened, depending on the volatility of underlying stocks and whether they are European-style or American options.

NDFs require no margin as they are cash-settled with a predetermined strike price.

Settlement procedures

Index options’ expiration is on the third Friday of the expiry month, so exercises may take place as early as one business day before expiration if assigned. Exercises can also be assigned on the last trading day before expiry, but liquidation will still occur on the third Friday.

NDF does not have an exercise procedure, and liquidation will occur at market close on the expiration day. On that day, all open NDF positions held by investors will receive their cash settlement as if they had sold their positions in the market at the expiry.

Strike price selection

Index options have a fixed strike price, which means that the holder has no choice in choosing a specific stock or stocks to be bought/sold. In general, the nearest expiration index option with the highest trading volume is chosen for opening positions.

NDFs do not have any fixed strike prices, so investors can choose from HSI NDF futures contracts with different expiry dates and choose one with higher liquidity during their trading time frame.

Dividends and corporate actions

Dividends and corporate actions may affect intrinsic value when index options are exercised before expiration. If an investor exercises his option early, he will be assigned to the current market price stocks. Therefore, an investor can miss out on receiving a dividend if he does not hold the underlying stock when the dividend date occurs. In addition, there might also be problems with dividend withholding tax.

NDFs allow investors to trade without knowing which specific stocks in the Hang Seng Index they will receive once it expires. When an HSI NDF expires, all open positions in that expiry month receive a cash settlement based on its predetermined strike price instead of being assigned shares from specific stocks from the index.

If you want to learn more ETF trading have a look at Saxo.