Options trading has a long and storied history, dating back to ancient times, but in today’s dynamic financial landscape, it offers a wealth of possibilities for investors seeking to diversify their portfolios and optimise returns.
Whether you aspire to speculate on market movements, protect your investments, or generate a steady stream of income, this article is designed to equip you with the knowledge and tools needed to master options trading effectively.
A historical approach to option trading
Options trading has a long history that dates back to ancient Greece and Rome, but it was in the Golden Age of the Netherlands in the 17th century when options trading began to take a form quite similar to the one we have today.
During the 17th century, Amsterdam became the world centre of trade thanks to the Dutch East India Company, one of the first companies to issue stocks and bonds to investors.
Consequently, the first traders surfaced, engaging in contracts that granted them the right to buy or sell these stocks and bonds at a predetermined price on a future date. These pioneering contracts are widely acknowledged as the precursors of modern financial options.
Notably, during the famous tulip bubble, options played a significant role through derivative vehicles linked to the rights of tulip bulbs:
In the following centuries, options trading continued to evolve and became more sophisticated. In the 20th century, with the evolution of computing and the creation of advanced mathematical models such as the Black-Scholes model, it was possible to value options more accurately.
Nowadays, options trading is an integral part of financial markets.
Options are used for both speculation and hedging purposes and are traded on a variety of underlying assets, including stocks, indices, commodities, and currencies.
What are financial options?
Financial options refer to contractual agreements that provide their holder with the right, but not the obligation, to either buy or sell an underlying asset (such as stocks, bonds, commodities, futures, etc.) at a predetermined price, known as the strike price, on or before a specified date, known as the expiration date.
There are two main types of options:
These options grant the buyer the right, but not the obligation, to buy an asset at an agreed price at a future date.
If the price of the asset increases, the option holder can buy the asset at the lower agreed price and sell it at the current market price, thus making a profit.
These options give the holder the right, but not the obligation, to sell an asset at an agreed price on a future date.
If the price of the asset decreases, the option holder can buy the asset in the market at a lower price and sell it at the higher price agreed in the option, thus obtaining a profit.
Characteristics of financial options
The expiration date of an option marks the final day on which the option can be exercised. Once this date passes, the option becomes worthless.
The strike price, also known as the exercise price, denotes the price at which the underlying asset can be bought or sold. This price is established when the financial option is created.
The premium represents the cost paid for the financial option. Its determination is influenced by various factors, including the price of the underlying asset, market volatility, and the time remaining until the expiration date.
Minimum capital required for options trading
The minimum capital required to trade in financial options can vary depending on the broker. Many brokers may require a minimum capital to protect themselves from potential losses. However, there is no rule regarding the minimum capital – so you will have to check with your chosen broker.
Value decreases over time
The value of an option can decrease over time. Every option has a designated expiration date, and as this date draws near, the option’s value reduces, even if all other factors remain constant.
This occurs because the likelihood of the underlying asset’s price moving favourably for the option holder decreases as the expiration date approaches. Consequently, the time value of the option, which represents the portion of its value unrelated to the difference between the underlying asset price and the strike price, declines.
Traders refer to this effect as “time decay,” and it is quantified using the Greek letter “theta”.
It is important to note that time decay does not affect all options equally. Options that are in the money or near the money tend to lose value more quickly than options that are very in or out of the money. In addition, time decay tends to accelerate as the expiration date approaches.
Possibility of unlimited losses
Financial options can be powerful tools for risk management and speculation, but they also come with significant risks. In particular, some types of options contracts can theoretically lead to unlimited losses.
How can this happen? There are two reasons:
- Call Option Sale: if you write a call option (so you have to sell the underlying goods) but you don’t have the assets (known as “naked call option writing), you are exposed to unlimited loss risk. This is because you are obligated to sell the asset to the option buyer at the exercise price, regardless of how much the asset price rises. If the asset price rises significantly, you can face huge losses as you would have to buy the asset in the market at the highest price to fulfil your obligation to sell it at the lowest price agreed in the option, in other words, you are short of that asset, and you know that a short position in assets can lead to unlimited losses.
- Put Option Purchase: Similarly, if you write a put option and you want to sell it, you will have to buy the asset at the strike price if the option is exercised by its buyer.
It is important to keep in mind that these are the theoretical risks associated with financial options. In practice, a variety of strategies can be used to manage these risks, such as the use of stock order types and hedging, and learning how to use covered call and protective put.
What is the purpose of trading with options?
Trading with financial options serves various purposes, with speculation and hedging being two of the most common objectives.
Options offer an avenue for speculating on the future direction of underlying asset prices. For instance, if an investor anticipates that a stock’s price will rise, they can purchase a call option for that stock. Should the stock price surpass the option’s exercise price, the investor has the option to exercise it, buying the stock at the predetermined exercise price and then selling it at the prevailing market price, thus generating a profit.
However, it’s important to note that most options trades are not initiated with the intent of exercising them. Rather, traders often focus on the fluctuation of the option premium price.
As the price moves in their favour, the option premium appreciates, allowing the trader to benefit from the price difference without the need for exercising the option. This is where selling options comes into play, enabling traders to essentially “bet” on what will not occur in the market.
In most cases, these strategies centre around speculating on the option premium price rather than the actual exercise or assignment of the option.
Options can be effectively used to safeguard an investment portfolio against potential losses, a practice known as hedging.
Suppose an investor holds a substantial number of shares in a company but is concerned about a potential decline in their value. In that case, they could purchase put options for those shares. If the share price indeed falls, the put option would increase in value, partially or fully offsetting the loss in the value of the shares.
This strategic application of options helps in mitigating the risk associated with an investment portfolio.
How does options trading work?
The following measures describe how the price of an option changes in response to different factors:
- Delta: It represents how much the price of an option changes in response to a one-point change in the price of the underlying asset. If Delta is 0.5, for example, the option will change 0.5 units for each 1-unit change in the price of the underlying asset.
- Gamma: It measures the rate of change of Delta, indicating how the option’s Delta will change as the price of the underlying asset changes.
- Theta: Theta represents the time decay of the option, that is, how much value the option loses with each passing day.
- Vega: It shows how much the price of the option changes in response to a change in the implied volatility of the underlying asset.
- Rho: It represents how much the price of an option changes in response to a change in the interest rate.
- Strike: or exercise price is the price at which the option holder can buy or sell the underlying asset.
An option can be closed at any time by either of the two parties, both the seller and the buyer. Once this is done, each party assumes the change in the premium paid or received and assumes the loss and gain.
Option status according to the relationship of the strike price with the price of the underlying asset
The ITM, OTM and ATM acronyms refer to the terms “In the Money”, “Out of the Money” and “At the Money”, respectively, and are used to describe the relationship between the current price of the underlying asset and the option’s strike price.
- In The Money (ITM): For CALL options, an option is ITM if the current price of the underlying asset is higher than the strike price. For PUT options, an option is ITM if the current price of the underlying asset is lower than the strike price.
- Out of The Money (OTM): For call options, an option is OTM if the current price of the underlying asset is lower than the strike price. For put options, an option is OTM if the current price of the underlying asset is higher than the strike price.
- At The Money (ATM): An option is At The Money if the current price of the underlying asset is equal to or very close to the option’s strike price.
What assets can be traded with options?
Options provide a versatile means of trading various assets. Here are some of the most common ones:
- Shares: It is customary for options contracts to involve negotiating with packages of 100 shares. Trading options on individual stocks is one of the most prevalent and accessible forms in the market.
- Raw materials: Futures and options contracts on raw materials are essential tools for traders and hedgers dealing with commodities. These contracts provide valuable risk management and speculative opportunities.
- ETF: Options can also be traded on ETFs, offering remarkable flexibility. As there are ETFs covering a wide range of themes, such as raw materials, specific sectors, indices, and currencies, traders have ample choices to suit their investment preferences.
- Futures: Surprisingly, there are also options available on the most heavily traded futures. These include futures related to raw materials, major currencies, and indices. While options on futures provide substantial flexibility, it’s important to note that they often require a larger capital investment to trade.
- Indices: Trading options on indices is a popular choice among investors. It’s essential to understand that options on indices do not involve physical delivery; instead, they are settled in cash. This means that the final settlement is made in cash, as the index itself cannot be traded directly.
How to trade with options step by step? | Practical example with Interactive Brokers
We have now reached the moment you’ve been waiting for – a practical guide to trading options with clear visual examples. Let’s dive in!
Step 1: Open an account with Interactive Brokers
The first step is straightforward: you need to open an account with Interactive Brokers (the selected broker for this example) and follow the steps provided by the registration process. Rest assured, it’s not overly complicated, and the entire process should take no more than 10 minutes.
To get started, simply click on the button located at the upper right corner of the Interactive Brokers homepage.
Step 2: Make a deposit
Once your Interactive Brokers account is set up, it’s time to make a deposit. Interactive Brokers does not have a minimum deposit requirement, so you can start with any amount of capital. However, for efficient trading, it’s recommended to start with at least £3,000.
Step 3: Look for options
The SPX, representing the S&P 500 index, is a highly traded asset with options. However, since it may require substantial capital to start, we can opt for the SPY, an ETF that tracks the same index, making it more accessible for modest accounts. While the SPX offers more advantages when trading options, the SPY is the most actively traded asset on the American stock exchange today.
Selecting the right expiration and strike prices depends on the strategy you want to employ.
For example, a simple strategy involves buying a CALL option if we anticipate a bullish move or buying a PUT option if we expect a bearish move.
It’s essential to use limit orders to prevent unfavourable prices due to sudden price gaps.
Step 4: Understanding premium price movements
During an extended sideways period, the premium price reduces due to the effects of time decay mentioned earlier. However, when the price finally makes a significant move, the premium price skyrockets and accelerates quicker than the index itself as it approaches the strike price.
Assume you purchase an option that is already in the money (ITM) from the beginning, where time decay has a less pronounced impact. In this case, the option corresponds to a strike price of 400 and consistently trades above it, leading to the option price being less affected by the passage of time.
However, if we consider an option with the same expiration but much further out-of-the-money (OTM), meaning the strike price is much higher, the percentage-wise change in the option price is much more dramatic, both in its reaction to the upside and during sideways movements.
Understanding how premium prices react to various factors is crucial for effective options trading, enabling you to make well-informed decisions based on your chosen strategies and market analysis.
Two trading strategies with options for beginners
Here are two of the most popular trading strategies with options for beginners.
The strategy consists of the successive sale of PUT and CALL options to generate income from the premiums of the options. This approach requires a long-term commitment and is based on the idea of owning the underlying shares.
First, you start selling a put option of a stock that you wouldn’t mind having in your portfolio.
- If the option is not exercised before its expiration, you keep the premium you have earned from selling the option.
- If the option is exercised (because the stock price falls below the exercise price), you are obligated to buy the stock at the exercise price, which will be higher than the current market price. Now, the stocks are yours and, in theory, you bought them at a price lower than what you were willing to pay when you sold the put option.
Then, once you own the stocks, you sell a covered call option (Call) on those stocks, preferably OTM. This means that you are selling someone the right to buy your stocks at a certain price.
If the option is not exercised before its expiration, you keep the premium and still own the stocks. If the option is exercised (because the stock price went above the exercise price), you sell the stocks at the exercise price and keep the premium. From here, you can start the process again by selling another PUT.
The Iron Condor is an advanced options strategy that allows you to make a profit if the price of the underlying asset remains within a specific range for a certain period of time. It is a strategy that benefits from the passage of time.
The strategy is built by combining two vertical credit spreads: a put spread and a call spread. A “put/call spread” is an options trading strategy that involves buying and selling put/call options on the same underlying asset with different exercise prices (strike prices) and the same expiration date. This strategy is designed to limit both potential profit and loss.
- First, you sell a put spread. This is done by selling an out-of-the-money (OTM) PUT and buying another with an even lower exercise price. The purpose of this is to limit your risk to the downside. You receive a premium for selling the put spread.
- Then, you sell a call spread. You sell an OTM CALL and buy another CALL with an even higher exercise price. This limits your risk to the upside. You also receive a premium for selling the call spread.
By combining these two credit spreads, you have created an Iron Condor. Your maximum profit is the sum of the premiums you have received for selling the put and call spreads. This profit is realised if the price of the underlying asset remains between the strike prices of the sale and purchase options that you sold at expiration.
Your maximum loss is the difference between the exercise prices of the sale or purchase options that you bought and sold, minus the premiums received. This loss is realised if the price of the underlying asset is below the exercise price of the puts spreads or above the exercise price of the call spreads.
Things to keep in mind before starting to trade with options
Options trading, like any form of investment, carries inherent risks that investors must understand and manage. Here are some of the most common risks associated with options trading:
- Total loss risk: If an option expires worthless (out of the money), the investor will lose the entire premium paid for the option. Although this loss is limited to the premium, it can represent a significant amount of money. Options offer leverage, which can amplify gains, but it also means that losses can be magnified under certain circumstances.
- Volatility risk: Volatility is a measure of how much the price of an asset fluctuates. Since the value of an option is directly related to the price of the underlying asset, high volatility can lead to large changes in the value of an option. It’s crucial to understand volatility dynamics and their impact on option prices before diving into options trading.
- Exercise risk: If you are the seller of an option and the option is exercised, you are obligated to buy or sell the underlying asset at the strike price. If the exercise price significantly deviates from the current market price, it could lead to substantial losses.
- Time risk: As mentioned earlier, the value of an option diminishes over time due to time decay. This means that you need the price of the underlying asset to move in the anticipated direction before the option expires to make a profit. For sellers of options, time decay can work in their favour, but it’s essential to recognise that selling options comes with potentially unlimited risks.
- Liquidity risk: Some options may lack liquidity in the market, making it challenging to buy or sell them at desired prices. Limited liquidity can hinder closing options positions promptly and may result in wider bid-ask spreads, reducing profits or increasing losses.
- Complexity and risk of misunderstanding: Options are complex financial instruments that demand a good understanding of their mechanics. If you don’t fully comprehend an options transaction, you may face unexpected losses. Therefore, it’s vital to educate yourself thoroughly about options before engaging in trading.
Platforms for trading options
Platforms for trading options are not as intuitive. They can be challenging to navigate, and certain functionalities may be difficult to understand, often requiring specialised training.
|forex options, share options, stock indices, commodities||Variable (i.e., low spreads)|
|Exante||Over 270,000 options from global markets||From $1.5 per contract|
|DEGIRO||Over 10 markets available||€0.75/contract|
Have a look at the best brokers to trade options for more information.
Alternatives to options trading:
- How to invest in the stock market
- Stock market for beginners
- Dividend investing
- Investing in commodities
- Futures trading
- CFD trading
Trading with options: summary
While a limited balance may restrict certain operations, the vast array of underlying assets available today allows exposure to almost any market at reduced costs. Keeping the initial investment small minimises the toll of learning and allows room for mistakes.
Risk management is an essential skill to work on. When buying options, it’s crucial to recognise that even if they close at a high price, unforeseen events can cause their premiums to drop to zero or change drastically overnight when the market reopens.
Relying on luck is not a sustainable approach. It’s crucial to understand the potential outcome if the trades result in a total loss.
When dealing with trading strategies, ensure you have a thorough grasp of their mechanics, particularly understanding your maximum loss.
Having said that, options trading offers one of the most versatile and potentially rewarding opportunities. The key is to take the first step and start. This guide has provided you with the essential step-by-step process to begin trading options from scratch. It’s a matter of initiating action and embarking on this exciting journey.
What are the main benefits of trading with options?
Firstly, options provide a higher degree of flexibility compared to other financial instruments, allowing investors to profit from various market conditions, including bullish, bearish, or neutral trends. Additionally, options trading allows for leveraging positions, enabling traders to control a more substantial asset value with a smaller investment.
Moreover, options can serve as effective risk management tools, providing hedging opportunities to protect investment portfolios against potential losses.
What are the key differences between call options and put options?
A call option grants the holder the right, but not the obligation, to buy the underlying asset at a predetermined price (the exercise price or strike price) on or before a specific date (the expiration date). On the other hand, a put option gives the holder the right, but not the obligation, to sell the underlying asset at the exercise price on or before the expiration date.
How can traders manage the risks associated with options trading?
Effective risk management is crucial in options trading. To manage risks, traders should adhere to several key principles. For example, diversification is essential to spread risk across different assets and strategies. Avoiding over-concentration on a single position can mitigate the impact of adverse market movements.