Options trading allows you to hold a contract to buy or sell any underlying asset at a certain price over a certain period of time. This can be a much safer way to invest with high leverage compared to CFD’s. Read on to understand the basics!
What is options trading?
Options trading involves buying and selling options as contracts that give the investor the underlying asset at a set price if it changes price within a set timeframe. Buying and selling options are done through contracts. There are two fundamental types: a call option lets you buy shares at a later time whereas a put option allows you to sell shares at a later time. For example, if you expect the price of gold to rise from £1,200 to £1,300 over a couple weeks you can buy a call option that allowed you to buy the market at £1,250 at any point over the next month. If the price of gold rises above £1,250 (the strike price) before the month is out you will be able to buy the market at a discount. However, if the price stays below the strike price then you lose the premium you pay for your position. So essentially, you are at risk of losing £50 if the strike price is not hit but if the price goes above the strike price you have an unlimited profit potential.
In the UK you typically trade options using spread bets or CFDs. This works instead of trading them directly. Trading options as leveraged products works similarly to CFDs or spread bets which allow you to speculate movement without actually owning the underlying asset. This is both a blessing and a curse as it magnifies your wins but also your losses. Your risk is limited to the margin you paid to open the position although it is important to note that when selling call or put options you have a potentially unlimited risk.
What sets the difference between options and futures is that options allows you to withdraw from the options contract at any point with your loss set a premium (the cost of the option) that is based on a percentage of the assets market price. This means there is a much lower risk than trading futures.
When trading options a contract will have the following elements:
- Stock ticker
- Date of expiration
- Strike price
- Call or put
- Premium price
Put together this would look something like this:
APPL 26/03/2021 400 Call @ 5
What are call options?
Buying a call option gives you the right, but not obligation, to buy the underlying market at the strike price before a certain date. This lets you make profit as the market value increases. The fee you are paying to buy the call option is called the premium (it’s essentially the cost of buying the contract which will allow you to eventually buy the asset) which is comparable to making a down-payment. You pay for a contract that expires at a set time but allows you to purchase an asset at a predetermined price. You will have the choice to renew your option as their value decays over time.
As with all trading you can also sell, in this case you will have the obligation to sell the market at the strike price if the option is executed on expiry.
What are put options?
There are also put options which give you the right, but again not the obligation, to sell a market at the strike price within the expiry. In this case the more the market price drops, the more profit you make. If you choose to sell put options you will have the obligation to buy at the strike price if you exercise your option.
So how do you calculate an option’s price?
There are three factors that affect the premium you pay when trading options which work to determine the likelihood the underlying market price will be above or below the options strike price at expiry.
- How high or low the market is compared to the strike price: The further below the call options strike or the higher above the put options strike the higher the premium you are required to pay. This is as there is a high chance that the option will expire with value.
- The expiry date: The longer the option is open before it expires the more time there is for the market to pass the strike price. This means the closer you get to the expiry date the lower the chance that the option will expire in profit so will lose value.
- Volatility: The more volatile the market is the more likely the price will pass your strike price. In actuality a higher volatility will increase an options premium.
Risk when trading options uses Greek symbols for each variable that affects price.
What are the safest options trading strategies?
The most simple and common strategy used involves buying a call option when you expect the market to rise. If this works out, then you will profit when you sell your option before the expiry or let time run out and exercise your right to buy at the strike and profit this way. This is a great strategy for beginners as you cannot lose more than the premium you pay when opening your option.
A more complicated strategy but one that is key to learn is hedging your investment. If you want to avoid the potential market fall you can buy a put option. A married put means if the asset price falls you would make gains on the put to help limit your loss.
What time frame should you use?
You can execute an options trade on a timescale from daily upto quarterly. If you want to open a position quickly whilst ensuring you have a lot of control over your leverage you can use daily or weekly options. Whereas if you’re looking at a longer-term movement in a market choosing monthly or quarterly options means you can know your risk upfront.
What are common mistakes to avoid when trading options?
Although you can, it isn’t always advantageous to to hold a call or put an option until the expiry date. If your option has increased enough (beyond the strike price) then you can close the contract to take the profit at that point. Holding out may give you a greater profit but especially in highly volatile markets there is a chance the market price will fall again just before the expiry.
Another common mistake is to not have an exit plan. By creating a plan before hand you can exit an option when you reach a loss or profit that you are happy with, similar to stop losses and take profits. This way, you can close your option with a profit or loss ou are comfortable with instead of letting the contract expire and the decision being taken from you.
One more thing to be wary of is that cheaper option premiums aren’t necessarily better as this means you option is more ‘out of the money’ meaning the investment is riskier and the potential for profit is much lower. The highest risk option is buying an ‘out of the money’ option as this means the underlying security is far from the profit line.
What are the pros and cons of options trading?
Options trading is pretty safe making it a great way for beginner traders to step up their game. Options are typically more resilient to changes in price direction changes allowing you to make profit over time without having to invest directly.
As with all trading there is some risk involved depending on the level of volatility of the market you choose. Options are typically more expensive if there is higher uncertainty meaning the more volatile the market is for that particular asset the riskier it is to trade.
At the end of the day if you understand what you are getting yourself into and are comfortable with the risk options can be very lucrative. Want to invest? We recommend eToro and easyMarkets for beginners.