What are options all about?
Options are, for our purposes, exchange traded contracts conferring on the owner, the right but not the obligation to buy or sell the underlying equity, or index.
Think of this as a gift or discount voucher that you have to use by a certain time-if you do nothing it will expire worthless. But these lose value over time.
Options are traded on metals, commodities, currencies, bonds, even the weather!
There are also specially constructed options called OTCs- over the counter-and these are traded between institutions and do not concern us as retail traders.
We trade ‘exchange traded options’ only-which are regulated by the exchange- The Ice.com so the prices quoted are 100% authentic, and the values guaranteed by the exchange.
There are two types of options- CALLs- conferring the right to buy, and PUTs, conferring the right to sell. CALLs and PUTs have a limited life-they expire on the third friday of the month.
How does this work in practice?
Example1: FTSE100 current level 6500 you buy a CALL(the right to buy) with a strike price (the level at which the option is set) at 6600. You pay 10 for this. Options on the FTSE are priced at pennies x1000 so this CALL option costs £100.
Someone else buys a PUT (the right to sell) option at 6400 and they pay 15, or £150. These options are set to expire on the third friday of the month, so for our purposes let’s say they have 3 weeks to run, and the following happens:
1.FTSE stays at 6500-the CALL is at 6600, FTSE is below this so the CALL expires worthless,and you have lost £100. The PUT is set at 6400 and you have lost £150.
2. FTSE jumps to 6700- the CALL at 6600 now has a value of 100(6700minus 6600) Remember you have the right to buy at 6600.
The 6400 put expires worthless and lost £150.
3. The FTSE drops to 6300, now the Put is worth 100, which is £1,000 in real money.The CALL expires worthless.
When you buy an option all you can lose is the amount paid. When you buy or sell a future you can set a stop loss,which may or may not save you from big losses.
Hope that is clear.
It is no different to buying and selling anything-all you are doing is buying the right to buy or sell-in the same way a car dealer sells you a £30,000 car that is not yet in stock. You pay a deposit of £1,000.
He takes the chance that he can buy that car for £27,000, but he has still taken your money. We can do this with options for a fraction of the cost of the anticipated profit.
The car dealer has the right to sell(PUT) in this example and you have the right to buy(CALL) as you paid the £1,000 deposit. Car prices fortunately do not fluctuate like the stock market so it’s a fair trade all round. You want the car at that price and he is happy to sell at the agreed price.
Why should I trust this method of trading?
The above FTSE trade is a very simple example with options purely being bought. You can sell them too, and this requires ‘margin’ an amount of cash held by your broker on deposit. This can be held in bonds, or equities too. Your investments do not have to sit idle, your share portfolio can stand as security.
So the above trade on FTSE is a simple options buy-but what if FTSE had stayed at 6500 and you had sold BOTH the PUT and the CALL? You’d have collected 25, or £250 and your margin requirement would be about £2,000. Thus your return is 12.5% in 3 weeks*.
When you trade a future or spreadbet you have to take a view and be prepared to lose frequently. Spreadbetting can keep losses low, however -which is fortunate as over 90% of traders lose their money, which is why there are a lot of Spreadbetting firms.
*However risk is ‘unlimited’ in theory-in practice……….. well that’s what this site is all about.
Why have I not heard of this before?
LIFFE- London International Financial Futures and Options Exchange only opened in 1982, and have never had any interest in the public.
This is why we are here.
No agenda, just a passion for what we do and the desire to spread the word, and help others through the trading journey.
By the way-what the car salesman did-that is the same as shorting a stock-you sell something you do not own. Now who would do that? Why your very own broker would rent out shares to people who wish to short a stock. Whose shares are they renting out? Why yours of course! And you thought they were lying idle……
FYI- ‘Naked shorting’ is when people have not rented the stock, but have taken a short position-this is not like an exchange traded contract which is what we trade. Naked shorting is no worse than naked longs by the way-and in the US a trader who deposits $10,000 has $20,000 buying power-effectively unfairly increasing the price of stocks, in my view.