Find out everything you need to know to start options trading: including which markets you can trade, what moves options prices, and how you can get started.
How to trade options
Options trading can offer a great number of benefits to traders – whether you want to speculate on a wide variety of markets, hedge against existing positions, or just get a little bit longer to decide whether a trade is right for you. In order to get started, you’ll need to follow these steps:
- Learn what moves options prices
- Understand the risks involved
- Choose an options trading strategy
- Decide how you’d like to trade options
- Create an account
Here’s a detailed look at all five.
What determines an option’s price?
An option’s price – meaning the premium that the holder pays the writer to buy the option – will change depending on several different factors. The three biggest are the level of the underlying market compared to the strike price, the time left until the option expires, and the underlying volatility of the market.
All of the factors work on the same principle: the more likely it is that an option will move above (calls) or below (puts) its strike price, the higher its premium will be.
Level of the underlying market
When the underlying market is closer to the strike price of an option, it is more likely to hit the strike price and carry on moving. So an option on EUR/USD with a strike price that’s 50 points away from the current level of the market will be less likely to become profitable than one with a strike price that’s 15 points away, and therefore should have a lower premium.
Time to expiry
The longer an option has before it expires, the more time the underlying market has to hit the strike price. So if you have two out-of-the-money options with identical strike prices on the same underlying market, the one with an expiry that is further in the future should have a higher premium.
Volatility of the underlying market
The more volatile an option’s underlying market is, the more likely it is that it will hit its strike price. So if a market sees a sudden uplift in volatility, options on it will tend to see a corresponding increase in their premiums.
What are the ‘Greeks’?
The Greeks are the individual risks associated with trading options. Understanding why option prices move is a great first step towards profitable trading, but to truly master this market you’ll need to grasp the Greeks – because by understanding each risk, you can take steps to mitigate it.
Here’s a quick introduction to each one:
- Delta – how much an option’s price moves for every point of movement in the underlying market. Delta is a measure of how movement in the underlying market will impact the price of your option, otherwise known as directional risk
- Gamma – how much an option’s delta moves for every point of movement in the underlying market. Gamma shows whether directional risk will increase if the underlying market moves
- Theta – how much an option’s price declines over time, or its time decay risk. An option with high theta (usually one with a short-term expiry) will rapidly depreciate in value as it nears its expiration date
- Vega – how much an option’s price moves when the volatility of the underlying market changes. An option with a vega of two will move two points when its underlying market’s implied volatility changes by 1%
- Rho – how much an option’s price moves when interest rates change. Rho can either be positive or negative, dependent on whether the option’s price will improve when rates go up (positive) or down (negative)
Options trading strategies
There are a huge number of options strategies you can utilise in your trading, from long calls to call spreads to iron butterflies. Here are a few to get you started.
Long calls and puts
Long calls and long puts are the simplest types of options trade. They involve buying an option, which makes you the holder. You’ll make a profit if the underlying market moves above (calls) or below (puts) the strike price by more than your premium, and the cost of the premium is also the maximum loss you can make from the trade.
If you own an asset and wish to protect yourself from any potential short-term losses, you can hedge using a long put option. This strategy is called a married put.
Short calls and puts
In a short call or a short put, you are taking the writer side of the trade. The simplest of these is a covered call position, where you sell a call option on an asset that you currently own. Then if the price of the asset that you own doesn’t exceed the strike price of the option you’ve sold, you can keep the premium as profit.
You can also write call options when you don’t own the underlying asset, which is known as an uncovered or naked call. However this is a risky strategy, as you may end up having to pay for the full cost of the shares in order to sell them at a loss to the holder.
Straddles and strangles
You aren’t limited to trading a single option at a time. A straddle, for instance, involves simultaneously buying both a put and a call option on the same market, with the same strike price and expiry. By doing this you can profit from volatility, regardless of whether the underlying market moves up or down. But if no volatility occurs you’ll lose your premium.
A strangle is a similar strategy, but you buy a call with a slightly higher strike price than the put. This means that you need a larger price move to profit, but will typically pay less to open the trade because both options are purchased when out of the money.
And, of course, you can take the other side of both straddles and strangles – using short positions to profit from flat markets.
Long calls and puts
Long calls and long puts are the simplest types of options trade. They involve buying an option, which makes you the holder. You’ll make a profit if the underlying market moves above (calls) or below (puts) the strike price by more than your premium, and the cost of the premium is also the maximum loss you can make from the trade.
If you own an asset and wish to protect yourself from any potential short-term losses, you can hedge using a long put option. This strategy is called a married put.
Spreads
Spreads involve buying and selling options simultaneously. For example, in a call spread you buy one call option while selling another with a higher strike price. The difference between the two strike prices is your maximum profit, but selling the second option reduces your initial outlay.
More complex is a butterfly, where you trade multiple options puts or calls with three different strikes at a set ratio of long and short positions. In doing so, you can earn profits when volatility is low, without excessive risk. There are a few different types of butterfly strategy: such as the condor, iron butterfly and iron condor.
Two ways of trading options
As well as deciding which options trading strategies you’d like to employ, you’ll also need to choose how you’d like to buy and sell options.
- Trading options with a broker
Listed options are traded on registered exchanges, just like shares. And like shares, 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’ll deal on their platform, and they’ll execute your order on the actual exchange. You’ll usually pay commission on each trade.
- Trading options with CFDs
When you trade options with CFDs, instead of getting the right to buy or sell the underlying market you are getting the right to buy or sell CFDs on it. CFDs will always replicate the price of the underlying market, so your profit or loss would be the same as when trading with a broker – minus your costs to open a position.
Instead of signing up with a broker, you’ll need an account with a leveraged trading provider. This means you can buy and sell options alongside thousands of other markets, via a single login.
Find out more about CFD trading.
Create an account and get started
To deal on options prices with IG, first of all you’ll need to open an account. It only takes a few minutes to create an account, and there’s no obligation to add funds once it’s live.
You will need to fund your account, though, before you place your first trade. If you’d like to trial options strategies without risking any capital, you can try a demo instead – which gives you R1,000,000 virtual funds to trade over 15,000 markets, including a wide variety of options.
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