What is options trading?

Learn about options trading, which lets you lock in a price without the obligation to buy

What is options trading?

Options trading offers the right to buy or sell at a specific price on or before a certain date. They differ from futures in that there isn’t an obligation to buy.

The right to buy is called a “call option” while the right to sell is called a “put option”. If the price goes up and you have a “call option” then you have the opportunity to earn a large profit, if you have a “put option” then you lose the premium you paid. The opposite is also true.

You can trade options on:

  • Stocks and shares
  • ETFs
  • Currencies
  • Indices
  • Bonds

Options example

Let’s say you see a new development of flats in your local area – you think that you’d like to buy one of them, but only when they’re finished. You never know, they might choose to put carpets in the bathrooms.

You could buy a call option to purchase the home for its current value between today and four years time. It’s like a non refundable deposit for the home. Of course, the developers won’t give you this for free, but it could be in their best interests to sell you this option as it could get some initial money and might lead to a sale.

Now, say you pay £30,000 as a down payment for the flat, and three years later, the flats are done – and they didn’t put carpet in the bathrooms. If you want to, you can now purchase the property for the agreed price of £300,000.

If the area has suddenly become quite sought after, the value might have risen to £500,000, but, as you bought the option back when it was valued at £300,000, you can still have it for this price.

But, say the value has dropped and it’s now only valued at £250,000, you might not choose to use the option, as you can purchase the home for less and save yourself some money.

What’s the difference between options trading and futures trading?

At first, you might think that futures and options are exactly the same, but they’re not. The key difference between them is that with futures, you’re bound by a contract to purchase the asset at a specific price, while with options, it’s only a right, and you have a choice whether you want to do so.

Why do people trade options?

People choose to trade options as a means of making profit, to hedge risk against other investments or to speculate on price movements.

Speculation

Some people use options to wager on any potential price movements in the future. If you think the value will go up, then you might buy a stock or buy a call option. Buying a call option means that you have the chance to use leverage, so you can put down only a small amount of money, which is called the premium).

Hedging

This is what options were originally created for, and while it sounds like something you’d do to a hedge, it’s far from it.

Hedging is used to limit the risks that you are exposed to when trading, like an insurance policy for your investments. It’s a little complicated, but you can choose to buy a “put” option on a stock that you purchase – then, if the price goes against you, you can choose to sell at the agreed price. As these only offer the right to buy, you don’t have to purchase or sell when the prices work in your favour, which can help you limit your losses.

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All investing should be regarded as longer term. The value of your investments can go up and down, and you may get back less than you invest. Past performance is no guarantee of future results. If you’re not sure which investments are right for you, please seek out a financial adviser. Capital at risk.

Can I make a profit from options trading?

It’s possible to make quite a large profit from options trading if the prices work in your favour by more than the initial premium you paid.

Take the house example we used earlier. If the house valuation only raises by £30,000 when you choose to buy it then you’ll only break even as you paid £30,000 to secure the options contract.

What are the risks with options trading?

You’re at risk of losing the premium you put down, but as there’s no obligation to buy or sell, that’s the maximum risk you take. You should always make sure you only put down a premium that you can afford to lose.

Pros and cons of options trading

Pros

  • They’re cost effective. Options can be cheaper to purchase than shares, but can make you an equally large profit.
  • They carry less risk. When buying options, you’re only ever at risk of losing your premium, even if you’re wildly wrong about the future direction of a share price.
  • Extra flexibility. The ability to mimic the payoffs of specific assets, without being forced to invest huge amounts of capital upfront, gives investors more room to diversify. This makes it easier for them to create an investment strategy tailored to their specific needs.

Cons

  • If the price doesn’t move in your favour before the expiration date then you’ll lose the premium you paid.
  • Options aren’t available on all stocks and shares.

All investing should be regarded as longer term. The value of your investments can go up and down, and you may get back less than you invest. Past performance is no guarantee of future results. If you’re not sure which investments are right for you, please seek out a financial adviser. Capital at risk.

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