Options are about mindset and understanding concepts that are not easy to grasp, let’s try to explain.
Options are like insurance- you pay a premium to insure your house, and every year the insurance company collects those premiums for ‘free’. This transaction is based on trust. In the unfortunate event of your house burning down, the insurer has to cough up £1 million, say. The insurer knows that of the 100,000 houses that they insure, 7 will be burned to a crisp, so they have to pay out £7 million. But…….every household paid £100, so the insurer takes in £10 million in premiums, and pays out £7million. When you buy an option you are buying insurance, when you sell an option YOU become the insurer. You are saying you can manage the risk.
Examples: FTSE100= 7000 buy a put with strike* price 6800 for 30. FTSE drops to 6700 your option is worth 100 you made 100-30=70. Vice versa if you sold that put. (However you were paid 30, so 100-30 means you lost 70). So far so good? You are either paying insurance expecting an event to happen, or you are collecting premiums expecting the event NOT to happen. Is insurance a good business? Get it right and it’s incredible. Is it ethical to take money for nothing? This is the heart of the matter. The insurer MANAGES the risk, so you do not have to. Most of us are terrible at managing risk, which is precisely what options trading is about, understanding that risk and managing it. The first step is, we only trade the boring FTSE100 index.
*strike price is where the option is positioned in the options chain, which isthe list of options for monthly expiry(3rd friday of the month) You can buy a December option in January, for example. You can buy options for the next 2-3 years, which is handy if your crystal ball means you anticipate an event on a future date.
Here’s what the ftse options chain looks like. Please excuse the terrible editing but the strike prices(middle column) start from 4000 which is too far away from the FTSE price.
The ‘LAST’ price is the price at £10 per point at the end of the day, known as the closing or settlement price. (SET is the previous day’s settlement price). During the day the prices are live(15 minutes delayed unless you pay for live data). The 2 links below take you to options prices, and the ftse100.
There are no stupid questions, this is about the concepts of options. Please email us if you are unclear about any of this, because the journey is about to get amazing. [email protected]