Q.Dear Josh, I have been hearing a lot about options, how do they work?
A.Options are often considered complicated which, for me, is a misconception. There are two types of options, a call and a put. A call option is the right to buy a particular market at a fixed price on, or before, a specific date. For example, a FTSE 100 June 5,700 call gives you the right to buy the FTSE 100 at 5,700 at, or before, the June expiry date. You would buy that option if you think the FTSE 100 will rally beyond the 5,700 strike price, which means that you could buy the FTSE 100 at a cheaper level than it is trading for in the market. Similarly, a put option is the right to sell at a pre-determined level.
Q.Dear Josh, can I use options to help manage my risk?
A. Whether you are considering using options as a defensive tool (buying put options) or for upside protection (buying call options) they can be extremely useful in helping to manage the risk in your portfolio. Investors sometimes purchase options as a form of insurance in case an event occurs that may be detrimental to an existing position. A key benefit of using an option is that you know your liability from the outset. For example, if you think the FTSE 100 is overbought at its current level then you could consider buying a put option to profit from a potential correction in the market. Options have become more popular in the spread betting landscape since the onset of the financial crisis.
Q.Dear Josh, how can I best utilise options in my portfolio?
A.Options are extremely versatile and are a useful addition to a portfolio. For example, they can be deployed to speculate on future price movements with the added insurance that regardless of how volatile a market is, when you trade options your maximum downside is guaranteed. They can also be used to lower the risk in your overall portfolio. Equally, even when the markets are relatively static, options can be used to generate greater returns, or losses, even when there is low volatility in the markets. Because of this, spread betters should think about using options when they think that the markets will trade in a range. Options are a useful tool to ensure that investors reach their profit targets for the month, especially when the markets experience low volatility.