Options trading is not without risk – as we’ll explain in lesson 4.
However, it can be very attractive for retail traders as it gives you the opportunity to gain a very large exposure with only a small capital outlay – smaller than the capital required when trading the underlying instrument.
Options also allow you to profit within short or medium timeframes, rather than having to wait months or even years for an asset to move and generate a profit.
But the benefits don’t stop there. Options trading provides some important advantages over other approaches to the market.
First, it can allow you to make money no matter what the market is doing. It doesn’t matter whether the market is bullish, bearish or even static, there can be opportunities to profit with options trading:
- If the market is rising, you can make money by buying an asset below the market with a call option
- Alternatively, if the market is falling, a put option lets you sell an asset at a set price above the market. Of course, you can short the market by selling the underlying asset, if you know how, but options allow you to put a lot less capital at risk
- If markets go flat, with many forms of trading there’s not a lot you can do except hold on and hope things improve. But with the right strategy – as you’ll learn in this course – you can use options to make money from an asset that’s going nowhere
You don’t need to be familiar with the entire market. If you focus on a few favourite currency pairs, for example, and become familiar with their movements and patterns, you can plan an options strategy designed to earn money from those patterns.
Harnessing leverage
Options enable you to trade using leverage, meaning that the amount you pay to open is only a fraction of your trade’s potential full value. This enables you to command a large position in a market with a comparatively small payment. As a result, your potential profits are magnified – although the same goes for any losses you make.
How are options used?
There are three main reasons for trading options:
- To speculate on the price movements of various markets
- To limit your risk by hedging
- To trade on volatility – or the lack of it
Let’s look at these in turn.
Speculating with options
The flexibility of options has made them a popular tool for speculation. That’s because the prices that options trade at will vary depending on a number of 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 $1,300, for instance, will typically trade at higher price when gold is at $1,299 than when it’s at $1,200 – reflecting the probability that the strike price will be hit.
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.
Hedging
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.
It can be an important safety net if you are worried about volatility.
Profiting from volatility
Volatility can be a source of profit too. With options you can take positions that will let you profit from variability in the price of an asset – even when you believe that volatility will be low.
Maximising the power of leverage
With options it’s possible to pay a relatively small premium for market exposure, compared to other leveraged trading products like futures. As a result, options can potentially give large percentage gains from a relatively small initial outlay.
Example
Suppose you trade FTSE futures, buying one contract worth $10 per point at 6000. Your deposit is $300. If the FTSE then sees a 10% increase – climbing 600 points to 6600 – you make a profit of 600 x $10 = $6000.
But what if instead you buy a call option on the FTSE? Say the strike price is 6250, and you buy 30 contracts (one contract = $10 lot size) at a price of 10. Your outlay is again $300. In the same scenario as before, a 10% FTSE rally means your option will expire in the money by 350 points. And now your profit is 350 – 10 x $30 = $10,200.
So there’s potential for a much larger profit with the option, compared to trading futures. But keep in mind that the risk of rapid loss also increases whenever you use leverage.
Trading options with CFDs
One way to trade options is with CFDs. In this case, instead of getting the right to buy or sell the underlying asset, you’re trading on the actual value of the option.
Trading CFDs, or ‘contracts for difference’, allows you to speculate on whether an asset’s price will move up or down – without having to own the asset.
We offer CFD options at IG.
Question
Question 1
If the market is rising, you can make money by:
- a Buying an asset below the market by buying a call option
- b Buying an asset below the market by buying a put option
Reveal answer
Question
Question 2
If the market is falling, you can make money by:
- a Selling an asset at a set price above the market by buying a put option
- b Selling an asset below the market by buying a call option
Reveal answer
Lesson summary
- Option trading provides the opportunity to trade a very large exposure with only a small capital outlay – when buying options
- Options can allow you to make money no matter what the market is doing. It doesn’t matter whether the market is bullish, bearish or even static
- Option trading can be used to speculate on market movements
- Options may be used for hedging, limiting losses from a portfolio
- Because options are leveraged, the profits can be higher than buying an asset directly – although the risk of loss increases too
- You can trade options with CFDs
