What are options and how do you trade them?
Trading Floor News February 2, 2021 12:45 AM
Trading the underlying is a common way to speculate on markets including indices, stocks and forex. Most are simple to understand: if you buy and the price goes up, you earn a directly proportional profit. Options are more complex. Discover what options are and how you can implement an options strategy.
What is an options contract?
An options contract is an agreement that allows traders to buy or sell an underlying market at a specified “strike price” for a certain time period. The contract’s value will be ultimately dependent on the difference between the option’s strike price and the value of the underlying at expiry.
Options can be bought or sold at a price known as the premium at any time up until expiry. There are only two types of options:
- Calls: these options increase in value when the underlying product rises, similar to a long underlying position. Call options are considered ‘in the money’ when the underlying product is above the call strike price
- Puts: these options increase in value when the underlying product falls, similar to a short underlying position. Put options are considered ‘in the money’ when the underlying product is below the put strike price
At expiration, only ‘in-the-money’ options will have any value, otherwise they are considered ‘out of the money’ and expire worthless.
An option can be bought or sold, resulting in a long or short option position. The buyer of an option agrees to pay a premium in exchange for a potentially unlimited payout when the value of the underlying product moves beyond the option strike price. The option buyer’s risk is limited to the premium amount – so regardless of what may happen in the market, the maximum loss is always known upfront.
However, the seller of an option has potentially unlimited downside – they are paid the premium to take on this risk.
What are the four basic options strategies?
As there are only two types of options (puts and calls) and you can be long or short either of them, there are four possible positions you can have when trading an option. Let’s look at each.
- Long call option: you agree to pay a fixed premium for the right to participate in unlimited profits when the underlying market moves higher; your maximum loss is limited to the option premium
- Short call option: you agree to receive a fixed premium in exchange for assuming the obligation to pay an unlimited amount if the underlying market moves higher; your maximum loss is unlimited
- Long put option: you agree to pay a fixed premium for the right to participate in unlimited profits if the underlying market moves lower; your maximum loss is limited to the option premium
- Short put option: you agree to receive a fixed premium in exchange for assuming the obligation to pay an unlimited amount when the underlying market moves lower; your maximum loss is unlimited
How are options similar to insurance contracts?
Many traders like to think of options as insurance contracts, and this can be useful in understanding the major difference between long and short options. Purchasing options are very similar to buying insurance contracts. For example, you’d pay a set amount and then the insurance would payout a very large sum if certain parameters are met.
When a trader sells an option to open a short position, they are taking on the role of the insurance company and seeking to earn a profit by collecting the premium without having to make a large payout (hopefully).
How to profit in options trading
Trading options offers a broader range of possible outcomes compared to trading in underlying markets. Let’s conclude with a review of how an option trader would approach various market sentiments in the FTSE index.
- Extremely bullish view: ‘I believe the market is about to move much higher, and quickly’. In this case, they might buy FTSE call options for maximum leverage
- Somewhat bullish view: ‘I believe the market will climb, slowly and steadily’. Here, they might buy FTSE underlying market with a different derivative – such as CFDs or spread bets
- Mildly bullish to neutral: ‘I believe the market will remain relatively neutral’. In this case, they might sell FTSE put options to collect premium
- Extremely bearish: ‘I believe the market is about to break much lower, and quickly’. Here, they might buy FTSE put options for maximum leverage
- Somewhat bearish: ‘I believe the market will fall, slowly and steadily’. In this case, they might sell the FTSE underlying market with a different derivative – such as CFDs or spread bets
- Mildly bearish to neutral: ‘I believe the market will remain relatively neutral’. Here, they might sell FTSE call options to collect premium
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