Best Options Trading Platforms & Options Brokers 2023

Options Trading Explained

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.

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.

Puts & Calls

There are two principal types of options:

• Put options: Put options are the right to sell the underlying instrument,
• Call options: Call options are the right to buy the underlying instrument.

Advantages of using an options broker:

• Options are very cheap to trade
• You can trade on or off-exchange
• Risk is limited to premium (if you are a buyer)
• High potential returns versus risk when buying out of the money calls
• Lots of strategies to speculate on volatility and price movement
• Can be used to protect your long term investments

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.

Disadvantages of using an options broker:

• Options can quickly become illiquid and or worthless
• Risk is potentially unlimited if you write options
• Options are traded in fixed lots so exact exposure is hard
• You have to pay tax on options trading profits (unless spread betting)

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.

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.

Protecting your portfolio with options trading

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.

Buying versus writing (selling naked) options

The positions or obligations of the buyer or seller of an option are completely different.

• Buying: The buyer of an option can choose whether they exercise their rights to buy or sell the underlying instrument.
• Writing: 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 you with a choice to make based on your 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.

One thing to consider though is that thanks to the time decay chart 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.

Options trading versus 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.

DMA versus OTC options trading

The two different types of options broker in the UK are DMA and OTC (over the counter).

• DMA options trading would generally be more appropriate for sophisticated investors as you can buy and sell options. When you sell an option, losses are potentially unlimited so they are very high risk. DMA options through popular brokers like Saxo Markets and Interactive Brokers also allow their clients to trade on more illiquid assets, which would not be appropriate for inexperienced investors as they may not be able to close their positions.
• OTC options via spread bets and CFDs through popular brokers like IG or CMC Markets are more common for retail private investors as trading platforms will provide a selection of options on the most liquid and less volatile markets such as large-cap stocks and major indices. They may also have higher margin requirements than on exchange options, which reduces the risk for investors but still enables them to buy and sell options online.

Options trading terminology

Here are some of the major terms you will come across when you trade options through an options broker:

• • Options time series: 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 strike price: An options strike price are the prices at which the option owner can buy or sell the underlying instrument during the lifetime of the option.
  • Options values: 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.
  • Option depreciation: 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. 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.
  • Options volatility: 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.
  • Options Delta: Options delta is 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.
  • Options 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.
  • Options 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.
  • Options 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.
  • Options premiums: 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.