What are options?
Financial options let you trade on the future value of a market, giving you the right, but not the obligation, to trade the market at a set price on or before a set date. When you trade options with IG, you spread bet or trade CFDs on the price of an underlying option.
Trading options can form an important part of a wider strategy.
1. What are call options?
Buying a call option gives you the right, but not the obligation, to buy an underlying market at a set price – called the ‘strike’ – on or before a set date. The more the market value increases, the more profit you can make.
You can also sell call options. As the seller of a call option, you will have the obligation to sell the market at the strike price if the option is executed by the buyer on expiry.
2. What are put options?
Buying a put option gives you the right, but not the obligation, to sell a market at the strike price on or before a set date. The more the market value decreases, the more profit you make.
You can also sell put options. As the seller of a put option, you will have the obligation to buy the market at the strike price if the buyer exercises their option on expiry.
Spread bets and CFDs on options with IG are cash-settled at close. You’ll never have to deliver, or take delivery of, the underlying.
3. What is leverage in options trading?
Options are leveraged products much like CFDs and spread betting; they allow you to speculate on the movement of a market without ever owning the underlying asset. This means your profits can be magnified – as can your losses, if you’re selling options.
For traders looking for increased leverage, options trading is an attractive choice. By choosing your strike and trade size you get greater control over your leverage than when trading spot markets.
When buying call or put options as spread bets of CFDs with IG your risk is always limited to the margin you paid to open the position. However, it’s important to remember that when selling call or put options your risk is potentially unlimited.
4. How can you hedge with options?
Hedging with options allows traders to limit potential losses on other positions they might have open.
Say you owned stock in a company, but were worried that its price might fall in the near future. You could buy a put option on your stock with a strike price close to its current level. If your stock’s price is down below the strike at your option’s expiry, your losses are limited by the option’s gains. If your stock’s price increases, then you’ve only lost the cost of buying the option in the first place.
1. Understand options trading terminology
Traders use some specific terminology when talking about options. Here’s a rundown of some of the key terms:
- Holders and writers: the buyer of an option is known as the holder, while the seller is known as the writer. For a call, the holder has the right to buy the underlying market from the writer. For 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. When spread betting or trading CFDs on options with IG, you’ll pay a margin that works in a similar way to the premium
- Strike price: the price at which the holder can buy (calls) or sell (puts) the underlying market on the option’s expiry
- Expiration date/expiry: the date on which the options contract terminates
- In the money: when the underlying market’s price is above the strike (for a call) or below the strike (for a put), the option is said to be ‘in the money’ – meaning that if the holder exercised the option, they’d be able to 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), the option is said to be ‘out of the money’. If an option is out of the money at expiry, exercising the option will incur a loss
- At the money: when the underlying market’s price is equal to the strike, or very close to being equal to the strike, the option is referred to as ‘at the money’
2. Identify what determines an option’s price
There are three main factors affecting the premium, or margin, you pay when you trade options. All these factors work on the same principle: the more likely it is that the underlying market price will be above (calls) or below (puts) an option’s strike price at its expiry, the higher its value will be.
When you spread bet or trade CFDs on an option with IG, you’ll pay a margin that works in a similar way to a traditional option premium. The two terms are used interchangeably below.
- Level of the underlying market
The further below the underlying a call option's strike is, or the higher above the underlying a put option's strike is, the higher their premiums are likely to be as they are ‘in the money’ – there's more chance of them expiring with value.
- Time to expiry
The longer an option has before it expires, the more time the underlying market has to pass the strike price – so an out-of-the-money option will tend to lose value as it nears its expiration date and there’s less chance of it expiring profitably.
- Volatility of the underlying market
The more volatile an option’s underlying market is, the more likely it is that it will pass the strike price. So volatility tends to increase an option’s premium.
3. Learn about the Greeks
The Greeks are measures of the individual risks associated with trading options, each named after a Greek symbol. Understanding how they work can help you calculate the risk involved with each of the variables that affect option prices.
Delta is a measure of how sensitive an option’s price is to the movement of the underlying market. Assuming all other variables stay the same, you can use delta to work out how much impact market movement will have on the value of your option.
A derivative of delta, gamma measures how much an option’s delta moves for every point of movement in the underlying market.
Theta measures how much an option’s price decays over time. A high theta indicates that the option is close to the expiration date; the closer the option is to expiry, the quicker the time value decays.
An option’s vega measures its sensitivity to volatility in the underlying market, or how much the option’s value will change for every 1% change in volatility.
Rho indicates how much interest rate changes will move an option’s price. If the option’s price will go up as a result of interest rate changes, its rho will be positive. If the option’s price will go down, its rho will be negative.
4. Pick an options trading strategy
The simplest options trading strategies involve buying a call option or a put option, depending on whether you think the market is going to rise or fall. This is referred to as a long call or put. However, you can also take advantage of numerous other strategies to achieve different results when you’re trading options.
- Hedging your investment
If you own an asset and want to protect it against potential downwards market movement, you could buy a put option on the asset. This is called a married put – if the asset price drops, you would make gains on the put which would help limit your loss.
- Short calls
A covered call is the simplest short call position – you sell a call option on an asset that you currently own. If the price of the asset doesn’t exceed the strike price of the option you’ve sold, you keep the margin as profit. This strategy is often used to generate some income when you think an asset you hold is going to stay neutral. Writing a call option when you don’t own the underlying asset is known as an uncovered or naked call. This is a risky strategy, as you could end up having to pay for the full cost of the asset.
Spreads are when you buy and sell options simultaneously. When you trade with a call spread you buy one call option while selling another with a higher strike price. Your maximum profit is the difference between the two strike prices.
When you place a straddle, you buy or sell a call and a put position simultaneously on the same market at the same strike price. This gives you the potential to profit regardless of whether the market moves up or down, making them a good strategy if you expect market volatility but are unsure which way it will move.
Your break-even levels will be the strike price, plus or minus the sum of the two premiums on either side of the strike. Your maximum risk is still the premium you paid to open the positions.
The break-even levels only apply if you leave your option to expire.
A strangle is very similar to the straddle above, however you buy calls and puts at different strike prices. This means that you typically pay less to open the trade, but will need a larger price movement to profit. The trade is still limited-risk.
In the above examples, if you closed your position before expiry, the closing price is affected by a range of factors including time to expiry, market volatility and the price of the underlying market.
Find out more about options trading strategies.
5. Choose a market to trade options on
You can trade options on a huge number of markets with IG.
6. Determine the time frame during which the market is likely to move
Depending on the kind of trade you’re making, you can choose between daily, weekly, monthly or quarterly options to suit your goals.
Use daily and weekly options if you want to take positions on markets quickly, but with greater control over your leverage than when trading other products – such as trading CFDs or spread betting on spot markets.
If you’re looking at longer-term market movement, monthly and quarterly options mean you can take positions up to three quarters before expiry – plus you’ll know your risk upfront and usually save on funding charges.
7. Decide whether to buy or sell, and place your trade
Once you know the timeframe you’re going to trade, you need to determine whether you want to buy or sell a call or put option on the market you’re trading. The type of option you trade, and whether you buy or sell, will depend on whether you want to speculate on the market rising or falling. Remember that buying options is limited-risk, while selling is not.
Once you’ve decided whether to go long or short, you can choose the strike price and premium (or margin) you want to open the position at, and place your trade.
8. Monitor your position
Once you’ve opened a position, you need to keep an eye on market movement and the potential profit or loss of your position.
If the option is in the money, you may wish to close it before the expiry to maximise profit. Or if you aren’t in profit you can leave your position open to expiry, and, if it fails to move into profit, only lose the price you paid to open.
Ways to trade options
There are three ways to buy and sell options:
- Trade options with a broker
Like shares, listed options are traded on registered exchanges. You have to meet certain requirements to buy and sell options directly on an exchange, so most retail traders will do so via a broker. When you trade with an options broker, you deal on their platform – usually paying commission on each trade – and they execute the order on the actual exchange on your behalf.
- Trade options with CFDs
When you trade options with CFDs, your trade mirrors the underlying options trade. So, your profit or loss will be same as when trading with a broker – minus the commission to open. You need an account with a leveraged trading provider, like IG, to trade CFDs. Find out more about CFD trading.
- Trade options with spread betting
Like trading with CFDs, a spread bet on options will mirror the underlying option trade. A call option to buy £10 per point of the FTSE with a strike price 7100 would earn you £10 for every point that the FTSE moves above 7100 – minus the margin you paid to open the position.
You can spread bet on options alongside thousands of other markets, and there’s no tax to pay on your profits.*
Find out more about spread betting.
* Tax laws are subject to change and depend on individual circumstances. Tax law may differ in a jurisdiction other than the UK.
What is the definition of options trading in finance?
Options trading is the buying and selling of options – financial contracts that offer you the right, but not the obligation, to buy or sell an underlying asset when its price moves beyond a certain price with a set time period.
Can I profit from options trading?
Yes. If you buy an option you can make a profit if the asset’s price moves beyond the strike price (above for a call, below for a put) by more than the premium you initially paid before the expiration date. Your maximum risk is the premium you pay to open.
If you sell an option you stand to make a profit if the underlying market doesn’t hit the strike price before the option expires – you profit from the premium paid to you by the holder at the outset of the trade. However, your maximum risk is potentially unlimited if the market moves in favour of the option holder.
Can I trade stocks with options?
Yes, you can trade stock options. Rather than owning the actual stock, you have the right to buy or sell it at an agreed price on a specific date.
Can I buy a call and a put on the same stock?
Yes, there are various options trading strategies which involve simultaneously buying a put and a call option on the same market. These include straddles, strangles and spreads. Find out more about these strategies here.