What are options?
Options are derivative contracts that confer the right but not the obligation (on the purchaser of an option) to buy or sell a fixed amount of an underlying instrument at a set price during the lifetime of the option. In conferring those rights, the contracts provide the buyer with what’s known as optionality. Which we can think of as the right to choose whether to exercise their option and buy or sell the underlying instruments. Be that an index, a bond, a commodity, an individual share or cryptocurrency.
There are two principal types of options which are Puts and Calls.
Put options are the right to sell the underlying instrument, whilst Call options are the right to buy the underlying instrument.
Option Contracts have existed for some time, a type of options contact evolved in the Dutch Tulip mania almost 400 years ago. Like most derivative contracts options are designed to spread risk; however, their misuse can actually concentrate risk instead.
Options became increasingly popular with the launch of Financial Futures in the 1970s and 1980s, as mathematical models were developed that allowed traders to price and model options structures accurately and to make predictions about their future price movements rather than just trading them on intuition and experience.
Options have a finite life and are traded in what’s known as time series, for example, they may have a quarterly cycle of December, March, June, and September, or a monthly cycle of December, January, February, etc. Or these days even a weekly cycle.
Options contracts also have what is known as a strike price.
These are the prices at which the option owner can buy or sell the underlying instrument during the lifetime of the option.
The value of an option will vary depending upon where its strike price is relative to the current price of the underlying instrument. This is known as being in or out of the money, sometimes abbreviated to ITM or OTM. The degree to which an option is ITM or OTM determines its intrinsic value.
Other factors that affect option prices are the options lifetime or duration. This is known as an options time value. Note though that this decays over the lifetime of an option, and decays very quickly as the option approaches its expiry date. See the chart below which illustrates this time decay.
Options are generally tradeable in their own right and the combination of intrinsic and time value goes a long way to determining the ultimate value of an option. Though, we need to factor volatility into the mix to derive more accurate values for options.
Volatility is a measure of the propensity for price change and the frequency with which it occurs. It’s the volatility in the underlying instrument that an option is over, that we are interested in.
The maths of option modeling can be quite complex; however, we can think about it like this. We can derive an expectation of how volatile an instrument, such as a share or bond, will be in the future, by looking at its historic volatility and the current market conditions.
By combining those factors it’s possible to create a forecast or probability about how volatile the price of the underlying instruments will be in future, which is known as the implied volatility.
Higher rates of implied volatility mean a higher likelihood of sharp or outsize price changes in the underlying instrument. Which, in turn, means that there is more chance of an option moving into the money and therefore having a higher intrinsic value or being worth more.
Note though that the level of volatility says nothing about the direction of future price movements.
We also need to touch briefly on options sensitivities or what are sometimes called the Greeks:
Delta: This the sensitivity of the price of an option to a change in the price of the underlying. Deltas range between 0 and 1, the price of an option with a delta of 1, moves point for point with the price of the underlying.
Gamma: Gamma measures the rate of change in delta, effectively it’s a gauge of how stable the delta is for a given option, and it can be used to forecast the future prices of options and their chances of moving into the money.
Vega: Vega measures the likelihood of changes in implied volatility, which itself is a fundamental component of option pricing. Higher levels of volatility tend to push options prices higher. Lower levels can depress premiums. Tracking Vega can allow us to factor in those potential changes to an options theoretical value.
Theta: Theta measures the rate of time decay in an option under the curve above.
For example, the value of out of the money options (which have no intrinsic value) decay at a faster rate towards the end of their lifetime and have a higher theta as a result.
At this stage, we won’t concern ourselves too much with the application of the Greeks but we do need to know they exist.
How to trade options
Before we can trade options, we need to understand the following facts: Which are that the positions or obligations of the buyer or seller of an option are completely different.
The buyer of an option can choose whether they exercise their rights to buy or sell the underlying instrument. However, the seller of an option is obligated to take or make delivery of the underlying instrument, if they are exercised against, during the options lifetime.
That leaves us with a choice to make based on our appetite for risk. On the face of it being long (a buyer) of options is far less risky a proposition than being short (a seller) of options or is it?
I say that because thanks to the time decay chart above and the probabilities of an option not being in the money at the end of its life, the majority of options will expire worthless. Or will have been sold to close for a loss. In fact, as much as 70% of all options will expire out of the money that is with no intrinsic value, and because of expiry (limited lifetime) and no time value either.
When you trade options it’s common to hear people talk about buying or selling premium.
The option premium is the options price or the premium that you pay for the right to buy or sell the underlying. Or it’s the premium that you receive for selling options and becoming obligated to have make or take delivery of the underlying.
Effectively option sellers have a 30% chance of being exercised against whilst option buyers have a 70% percent chance of losing their premium if all options are held to expiry.
The table below shows us price data for a series of call options on the US computer company IBM. At the time the table was created IBM shares were trading at $124.92 meaning that all of the strike prices on the left-hand side of the table below $125 are In The Money whilst those with strikes above $125 are Out of The Money.
You can see that the in the money options have much higher bid-ask prices than those that are out of the money thanks to their intrinsic value. In this example, options with a strike price above $125 have no intrinsic value, only time value and any value deriving from the levels of implied volatility.
Let’s imagine we expect that the price of IBM is likely to rise over the next couple of weeks.
We could spend almost $125 per share and buy a physical holding or alternatively we could purchase some 130 calls which are offered at the price of $1.25 per lot. Options trade in lots or contracts in the same way that futures contracts do. In US options markets an equity option lot is over 100 shares of the underlying whilst in the UK single stock options are contracts over 1000 shares.
In this case, the cost of a lot of IBM $130 calls is $1.25 * 100 shares = $1250.00
That’s comparable to the cost of purchasing 10 shares of IBM stock at $124.92 per share so buy trading in the options we have geared our position 10-fold.
If the share price of IBM rises then the value of our $130 call options will increase, and the closer that the IBM price gets to $130, then the higher the value of our options should be. However, that price rise will be tempered or offset to a certain degree, by the amount of time it takes to happen and what that timespan represents in terms of the remaining lifetime of our options.
This tradeoff between duration/ time decay and what we might call the moneyness of an option is something that would-be options traders need to come to terms with.
Where are options traded?
Options trade on exchange or OTC for example UK single stock options trade on what was the LIFFE exchange now owned by the ICE or intercontinental exchange. FX Options on the other hand almost exclusively trade off-exchange or OTC. Your choice trading method and venue will be influenced by what you want to achieve with your options trading. Some brokers will offer you the ability to trade on exchange options whilst others will make options process to as either CFD or Spread Betting contracts however these will not be exercisable into the underlying assets the options are over. But if that's not important to you then you may be better off trading with a margin trading broker who may allow you to trade in fractions of a lot which you couldn't do on exchange.
Who should use options?
Options are considered to be complex products so a retail trader will need to demonstrate their understanding of the risks involved in trading them of course their suitability tests for all derivative trading accounts these days. But live options trading is certainly not for novices or inexperienced investors. Particularly if you are going to be doing anything other than buying puts or calls.
Most popular markets for options trading
Popular markets for options trading include stock indices and individual stocks, commodities such as gold and oil and trading options over ETFs is becoming more commonplace as well. The volatility seen in the markets during 2020 heightened interest in option trading and strategies and the volumes and values of options trading have picked up significantly because of that. Studies show that traders increasingly are attracted to weekly options and are using these short-term instruments to try and capture the momentum of US markets in particular.
Major risks of options trading
The biggest risk in options trading is that they have a finite life or fixed expiry date, unlike a CFD which could theoretically run forever. As we have already noticed the time value of options steadily decays over their lifetime and is one of the reasons why the majority of options expire worthless. That time decay is not linear in that time value decays very quickly at the end of an options lifetime. That means that short-dated options have very little or any time value within their price and therefore they are entirely composed of intrinsic value and short term volatility and in those circumstances the risk of losing all of the premium paid for the options is significant. However, there are also significant risks in selling options for example by selling or going short of call options you have an open-ended risk because there is no limit to how high the price of the underlying instrument. This risk can be ameliorated by selling call options against an equal holding in the underlying instruments. However, traders should be very clear about the risk profiles of their options strategies because this is an area where a little knowledge can be very dangerous indeed.
Major benefits of options trading
The benefits of options trading include having a fixed and known downside or maximum loss, if you are just long puts or calls then your maximum loss will always be the premiums you pay plus any commissions or fees. Options allow you to take a geared or leveraged position when compared to trading in the underlying. That is you can gain greater exposure for a smaller initial outlay. Strategies such as covered call writing can be used to create income streams to boost a portfolio's returns.
Using options to protect your portfolio
Options can be used for outright speculation but as we noted earlier in the article they are primarily designed to diversify or mitigate risk for example if you have a portfolio of FTSE 100 stocks and are feeling bearish of the market short term you might be reluctant to sell your stock holdings in case you are wrong.
However, you can take out an” insurance policy” by buying some put options that is the right to sell an underlying instrument for example buying put options on the FTSE 100 index with a notional value equivalent to that of your stock holdings. If done correctly any move lower in the value of the FTSE 100 and therefore your share portfolio should be offset by a corresponding rise in the intrinsic value of your FTSE 100 put options of course to crystallize those running profits on the put options, you will either need to sell or exercise them before they expire and before the FTSE 100 recovers.
Options compared to futures trading
The principal differences between options and futures trading revolve around the obligations that the respective contracts confer. Futures traders are obligated to make or take delivery of the underlying commodity they are trading at the end of the contact lifetime whereas in options trading only the seller of options has obligations buyer of options have the right to take action but not the obligation to do so. Options can be used to create positions that resemble futures contracts. So for example being long calls and short puts in the same instrument is a synthetic long in the underlying whilst being long puts and short calls in the same instrument create a synthetic short in the underlying instrument being traded.
All futures contracts have a value throughout their lifetime which is the current price times the size of the contract and any changes in the price of the underlying price are reflected in the PnL’s of the buyer and seller. Conversely, the values of options prices will change even if there is no change in the price of the underlying instrument, because of time decay and reductions in implied volatility. In those circumstances the value of out of the money puts and calls can quickly be eroded and only in the money options will have any value at all at the end of a contract's lifetime.
How to start trading options?
The first thing you need is a broker that offers access to the type of options you want to trade. You can compare options brokers in our options broker comparison table. All the brokers we feature are regulated by the FCA and offer access to on-exchange and OTC options. It's important to remember that whilst options trading can be a good way to hedge exposure they can also be a very high risk form of speculation so make sure you fully understand the risks before you start trading options.