When you trade in the traditional way you simply buy an asset if you think it will rise, or sell it short if you think it will fall. Trading options opens up some other possibilities.
There are several types of options, and understanding how they work is vital. In this course we’ll focus on vanilla options – a popular choice for traders who want to start expanding their strategy.
An option is a contract that lets you trade on the future value of a particular financial asset. When you buy an option, you’re paying a premium for the right to buy or sell the asset at a set price, on or before a set date when the option expires.
Options are similar to futures, in that they let you speculate on a future price – but unlike futures, there’s no obligation to trade if you don’t want to.
Example
Say you have an option contract that allows you to buy gold at $1300 for next week.
If gold hits $1325, for example, you could exercise your option and buy it for $1300, which is $25 less than the current market price.
But if gold stays below your option price, falling to say $1275, then there’s no obligation to buy it for $1300. By choosing not to trade, you’d avoid paying above the market price – although you would lose the premium you paid for the option.
How options work
There are two types of option: calls and puts.
- A call gives you the right, but no obligation, to buy an asset at a set price on or before a set date
- A put gives you the right, but no obligation, to sell an asset at a set price on or before a set date
Buy a call option, and you take a long position on its underlying asset. The more the price rises, the more profit you can make. Buy a put option, and you have a short position. The further the market drops, the more profit you can make.
You can also sell an option – but that’s a little more complicated, and we’ll look at it later in the course.
Calls and puts both have an expiry date. You don’t have to buy or sell if the market doesn’t move the way you expected, but once either option expires, it will become worthless. You lose the premium you paid for it, but nothing more.
So, with our gold example, a call option should mean that you pay a lot less to open your position than if you’d bought gold itself. If the price of gold goes up, you can buy it at a bargain price and profit from reselling it.
If you have a put option and the price falls, you can buy at a low price and profit by selling at the higher price agreed when you took out the option.
Alternatively, you could sell your option itself without ever exercising it – known as closing out – profiting from the price movement without committing a great deal of capital.
If the market doesn’t move in the way you expected, you don’t have to exercise your option, limiting your losses to what you paid for the option itself.
How options can generate a profit
When you buy an option contract, you aren't physically buying anything – no asset is actually transferred.
When you decide to exercise an option, on the grounds that doing so will earn you a profit, it gives you the right to buy the underlying asset from the option seller. At IG we’ll settle this with a cash payment.
What can you trade with options?
Options are flexible and allow you to trade a huge number of assets. Like futures, options can be used to buy and sell assets that would cause logistical issues, such as oil or gold.
With IG options, for example, you can trade assets such as:
- Forex including major pairs like EUR/USD, GBP/USD, USD/JPY and EUR/GBP
- Shares including FTSE® 100 stocks and a selection of leading US equities*
- Stock indices including the FTSE 100 and Wall Street
- Commodities including metals and energies
* Further equity options available via phone trading
When you trade options with us, you don’t actually own the underlying option – you’re simply speculating on its value using a CFD.
Understanding the terms
Options have some key terminology used by traders. Here are some expressions you may come across:
- Holders and writers: the buyer of an option is the holder, while the seller is the writer. In a call, the holder has the right to buy the underlying asset from the writer. In a put, the holder has the right to sell the underlying asset to the writer
- Premium: the fee paid by the holder to the writer for the option
- Strike price: the price at which the holder can buy (call) or sell (put) the underlying asset
- Expiry: the date and time when the options contract terminates. After expiry, the option is worthless. If the underlying market doesn’t hit the strike price before expiry, the holder can’t earn a profit
- In the money: when the underlying market’s price is above the strike (for a call) or below the strike (for a put), meaning the holder can exercise the option and 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), meaning that exercising the option will result in a loss
- At the money: when the underlying market’s price is equal or very close to the strike
What does options trading cost?
The cost of opening a position with IG includes an option premium and the dealing spread – the difference between the bid and ask price. The more likely it is that an option will move above (with calls) or below (with puts) the strike price, the higher its premium will tend to be.
There will be no commission for CFD options – our only charge is the spread.
How do options prices work?
Options pricing is complicated and doesn’t always move one-for-one with the underlying asset.
At IG option prices are set by our dealing desk, based on three key factors:
- The time to expiry ̶ the longer an option has before it expires, the more time the underlying asset has to hit the strike price, so the premium will be higher
- The current level of the underlying market ̶ the closer the underlying asset is to the strike price, the more likely it is to hit and pass the strike price. So an option 50 points away from the current level of the market will be less likely to become profitable than one with a strike price 15 points away, meaning it should have a lower premium
- The volatility of the market ̶ the more volatile the asset, the more likely it is that the option will hit its strike price. So options in a volatile market will see higher premiums
The premium you pay to open an option can be your maximum risk if you are buying. This is not the case if you are selling – we’ll explain more about that later in the course.
Lesson summary
- An option is a contract giving the owner the right, but not the obligation, to buy or sell an asset before a set expiry point
- Buying a call allows you to go long, while buying puts enables you to go short
- Options are flexible and allow you to trade a huge number of assets including forex, shares, stock indices and commodities
- The more likely that an option will move above (with calls) or below (with puts) the strike price, the higher the premium will be
- For bought options, the premium you pay to open is your maximum risk
