What are options and how do they work?

Discover the fundamentals of buying and selling in the options market.

What is an option?

An option is a financial product that enables you to trade on the future value of a market. When you buy an option, you’re paying a premium for the right to trade a market at a set price, before a set date when the option expires. Options are similar in this regard to futures – but unlike futures, there’s no obligation to trade if you don’t want to.

Say, for example, that you have an option contract that allows you to buy gold at $1300 for the next week.

If gold hits $1325, you can exercise your option and buy it for $1300, $25 less than the current market price.

If gold stays below $1275, then there’s no obligation to buy it for $1300. Though by not trading, you’ll lose the premium you paid for the option.

Are options leveraged?

Options are a leveraged form of trading – like CFDs – which is one major reason they’re attractive to many traders. 

Take the above as an example. By buying a gold option, you could have paid a lot less to open your position than if you’d chosen to buy gold itself. And if the precious metal moves up in price, you could sell your option on without ever exercising it – profiting from gold’s price movement without committing a lot of capital.

That makes options a powerful tool for traders, but also brings its own issues. Learn more about the drawbacks of options.

What are options used for?

There are three main reasons for trading options: to limit your risk by hedging, to buy yourself time to decide if a trade is right for you, or to speculate on the price movements of various markets. While they have other uses – such as in complicated spread strategies – the majority of traders will use options for one or more of these.

Hedging with options

Options trading was first devised as a hedging tool. Say you owned stock in a company, but were worried that its price might fall in the near future. You could buy an option to sell your stock at a price that’s close to its current level – then if your stock’s price falls, you can exercise your option and limit your losses. If your stock’s price increases, then you’ve only lost the cost of buying the option in the first place.

Buying time to decide

Another key use for options is to extend the time you have to decide about whether a trade is worthwhile. Here, instead of buying a market that you aren’t entirely sure about immediately, you buy the option to trade it before a set date in the future. If, further down the line, you decide that you want to buy the market then you can exercise your option. If not, then once again you’ve only lost the premium.

Speculating with options

The flexibility of options has also made them a popular tool for speculation. That’s because the prices that options trade at will vary depending on a number factors, including how much time you have left to exercise your right to trade, and the value of the underlying market. An option to buy gold for $1300, for instance, will typically trade at higher price when gold is at $1299 than when it’s at $1200. 

Speculators might trade options with no intention of ever exercising them. Instead, they’ll buy an option then sell it on when its premium increases. 

For more information on option price movements, see how to trade options.

 

The different types of option

Options come in two main varieties: calls and puts.

  • Calls give you the right, but not the obligation, to buy a market at a set price before a set date
  • Puts give you the right, but not the obligation, to sell a market at a set price before a set date

Buy a call option, and you’ll get a long position on its underlying market. The more the market’s price rises, the more profit you can make. Buy a put option, and you have a short position on the underlying market. The further the market drops, the more profit you can make. Once either option expires, it will become completely worthless.

Here’s how to calculate the profit or loss on an options trade:

Calls

Profit or loss = underlying market’s price – strike price – premium

Puts

Profit or loss = strike price – underlying market’s price – premium 

The components of an options trade

Options can seem complicated at first because of the terminology used by traders. Here’s a rundown of some of the key terms involved in options, and what they mean:

  • Writers and holders: the buyer of an option is known as the holder, while the seller is known as the writer. In a call, the holder has the right to buy the underlying market from the writer. In a put, the holder has the right to sell the underlying market to the writer
  • Premium: the fee paid by the holder to the writer for the option
  • Strike price: the price at which the holder can buy (calls) or sell (puts) the underlying market
  • Expiration date: the date on which the options contract terminates. After the expiration date, the option is worthless – so if the underlying market doesn’t hit the strike price before the expiration date, the holder can’t earn a profit
  • In the money: when the underlying market’s price is above the strike (for a call) or below the strike (for a put), meaning the holder can exercise the option and trade at a better price than the current market price
  • Out of the money: when the underlying market’s price is below the strike (for a call) or above the strike (for a put), meaning that exercising the option will incur a loss on the trade
  • At the money: when the underlying market’s price is equal to the strike, or very close to being equal to the strike

What can you trade with options?

One of the biggest benefits of options is their flexibility. You can trade a huge number of markets, and like futures options can be used to buy and sell assets that would otherwise cause logistical issues, such as oil or gold.
 
Here are some of the asset classes that you can trade with options, and the markets available with IG:
 
  • Forex. Including majors like EUR/USD, GBP/USD, USD/CHF and EUR/GBP
  • Shares. Including FTSE® 100 shares and a selection of leading US shares
  • Stock indices. Including the FTSE 100 and Wall Street
  • Commodities. Including metals and energies
You can also use options over both the short and long term. A daily option, for example, will expire at the end of the day – whereas weekly or quarterly options will have expiries further ahead.

Four things to consider before trading options

Deciding whether you want to trade options means weighing the benefits against the potential downsides:

Complicated market

Options are flexible, but they can also be complicated. Instead of buying a market in the hope that its price will increase, you have to factor in how much its price will increase and when the movement will occur.

Writing risks

The holder of an option can only lose the premium that they’ve paid, but the writer has many more risks to deal with. These can include early exercising if the holder decides to take up their right to buy or sell the underlying market, or a margin call.

Price volatility

The premium you’ll pay to buy an option is dependent on more than just the price of its underlying market – so before you start trading options you’ll need to learn what moves options prices.

Time decay

A significant part of an option’s value will often come from the remaining time it has before it expires. This value will diminish as it draws closer to expiring, making options extremely time sensitive.

Find out more about  the risks associated with options trading – and how to mitigate them. Or if you’d like to consider an alternative market, you can also use  CFDs to trade on price movements in forex, share, indices and more.

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FAQs

Are options derivatives?

Yes. The price of an option is dependent on the price of its underlying market, which means that options are a derivative of other financial assets. However, unlike other derivatives – such as contracts for difference options prices won’t always move exactly in-line with the underlying market. 

Can I trade CFDs on options?

Yes. Trading options via CFDs is similar to trading them on the open market. For instance, you can buy the right to trade ten FTSE 100 CFDs at 7100. Opening these positions doesn’t mean you have the obligation to trade, and you’ll pay a premium at the outset.

Learn more about trading options.

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