OPTIONS TRADING GUIDE
Options are a type of financial derivative that can allow people to benefit on rising or falling prices of assets without the same risk associated with normal futures or equities, via the payment of a premium.
For example, the buyer of an option has the right (but not the obligation) to buy or sell an asset on a specific date (or sometimes before) at a certain price, with limited downside risk.
Conversely, the seller of an option has the chance to gain the premium paid by the buyer. However, selling options can be extremely risky as there is the possibility for unlimited downside.
Options come in two forms; calls and puts. Calls allow the buyer to purchase a specified asset at a specific price at some point in the future. Puts allow the buyer of the option to sell a specified asset at a specific price at some point in the future.
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WHy trade options?
Risk Management
Options allow you to hedge out risk in your other investments. For example, imagine you are long a spread bet on Barclays. You may believe that in the long term the share price is likely to appreciate, however, you are worried about a short term fall in the shares. Using Options you can hedge out your short term risk by buying a short dated put option in Barclays.
Limited risk
Buying an option allows you to take a view on a particular asset with the peace of mind of a limited downside. Suppose for example you believe there is a chance oil prices could appreciate over the next 3 months, you could then buy a call option on Brent Crude. If you were wrong you would only lose your premium, if you were right you have unlimited upside. However, if you had taken out a normal futures bet on Brent Crude and were wrong, you could have potentially lost a lot more than the premium you would have paid for the Option.
Leverage
Buying an option gives you exposure to the asset in much greater size than the premium paid. However, leverage trading is extremely risky and you should always ensure you are aware of your total liability before trading.
Benefit from low volatility
Selling or writing options can allow you to gain premium during times of low volatility in the underlying asset. For example, you may believe that the stock market is likely to be flat in the next month. You could then sell a call and put option together in the UK 100 to gain the premium of the options as time ticked down to expiry. However, if the market did move quickly in either direction, you could be liable to make large losses (see risks below).
What are the risks?
Unlimited Risk
Selling options can result in unlimited risk. Suppose for example that you believed that gold prices were going to fall in the next few months. You could sell a Call Option in Gold to try and gain the premium of the option as the price of Gold fell. However, if Gold prices actually appreciated over this period, you would find yourself losing with unlimited liability till expiry
Time erosion
All options have an expiry point. You could therefore find yourself in a situation where you are correct in the long run, but still lose on your trade if your prediction doesn’t prove correct before the end of the option contract. In this scenario you would end up losing the whole premium you have paid without ever gaining from your correct trade.
Expensive
Buying Options can be an expensive way of taking a position in an asset. Since you have limited liability you tend to pay more for this privilege, in the same way you have to pay for insurance contracts. For example, buying an ‘at the money’ option tends to be more expensive than if you simply traded the underlying asset. For example, suppose the Germany 30 is trading at 12,500, a 12,500 Call option could be trading at 10 – 15. In this scenario you are paying 15 more than what you would if you simply bought the underlying product. However, conversely, you would also only be limited to 15 points on the downside should your bet turn out to be wrong (see benefits above).
Early exercise
Selling some options may mean you are at risk of being exercised early if the buyer chooses to take up their right to do so. This may mean you are liable for other costs, or are forced to sell or buy back your asset before you are ready (see FAQs for more info).
OPTIONS - KEY TERMS
Strike: Is the price at which the product can be bought or sold on expiry.
Put Options: give the buyer the right to sell an asset at a certain price (called the strike) on expiry.
Call Options: give the buyer the right to buy at a certain price (called the strike) on expiry.
Expiry: Is the date on which the product can be exercised (for European style options).
At-the-money Option: An ‘at-the-money’ option is one where the strike is at the current level of the underlying asset.
In-the-money Option: An ‘in-the-money’ option that has a strike which is currently in a beneficial position with respect to the underlying. E.g. a $1300 call for gold when the underlying is at $1500 or a $120 put for light crude when the underlying is at $100.
Out-of-the-money Option: An ‘out-of the money’ option is one where the strike is currently in a position which would not be beneficial to exercise eg a 6500 call on the UK 100 when the underlying is trading at 6000 or 900 put on SPX 500 when the underlying is trading at 1200.
European Style Option: The most common type of option used. This type of option can only be exercised on the expiry date (however, you can trade in and out of the premium up until expiry).
American Style Option: A type of option which allows the buyer to enact it at any point up to and including the expiry date.
Exotic Style Option: Options which allow for the expiry times to be tailed as the customer sees fit. Examples include Bermudan.
Delta Coefficient: The derivate of the option with respect to a change in the price of the underlying asset. In other words how much the premium of the option moves when the underlying moves one point, it could be anything from 0 to 1 for calls and 0 to -1 for puts, with most landing somewhere in between. Delta is always at its highest for deep in-the-money options, smallest at the extreme out-of-the-money option, and at 0.5 for the at-the-money option. Some traders use the delta as a measure of the likelihood of the option expiring "in the money".
Gamma Coefficient: The second derivative of Delta, i.e. the rate of change of Delta.
Vega Coefficient: The option’s sensitivity to the underlying volatility.
Theta Coefficient: The option’s sensitivity to a change in time.
