THE markets are a mystery sometimes, and it can be difficult to decide which way they are going to move. One way for spread betters to trade even if they don’t have a clear idea which direction prices are going is through options.
But how do you actually spread bet on an option? An option gives you the right, but not the obligation, to buy or sell an asset at a set price (referred to as the “strike price”) on a particular date (“expiry”). Call options give you the right to buy at the strike price; put options give you the right to sell at the strike. There are usually a wide variety of strike prices and expiries available, and you don’t have to keep the option until its expiry date – you can sell it on whenever the market is open.
Here is an example of using options to trade the FTSE 100. Say, for instance, that you think the FTSE 100 is going to be much higher next month compared to where it is today. You have two ways in which to spread bet on this strategy. Firstly, you could spread bet in the normal way and buy the index; alternatively, you could buy the 5,100 June call option. With the FTSE currently trading at 4,978, the option would cost 122 points (the difference between the strike price and the actual price).
Let’s say that on 18 June – its expiry date – the FTSE gets to 5,300. The option gives you the right to buy at 5,100 (the strike price) – so the option is worth 200 points (5,300-5,100).
The advantages of using an option is that the risk is fixed – the most that can be lost is the price you pay for the option. In this example the option cost 122 points – let’s say our trader bought £2 per point – then the maximum loss is £244 if the FTSE collapses even further from here.
However, to really benefit from options you need volatile markets, otherwise time decay can eat away at your profits. Options lose value as they near expiry, so, if the market only reaches 5,100 on the expiry date the trader will have been right on direction – but the option would expire worthless because of time decay. That can be extremely frustrating for any investor.
If someone else thought that the FTSE was going to drop even more during the next month, or at best only experience a small rise, then the FTSE 5,100 June call could be sold rather than bought. Taking into account the spread at the time of writing this it could be sold at 118 points, or £238 since you pay £2 per point for the option.
If we assume at expiry the FTSE is 5,100 then the option expires worthless and the trader has pocketed £238 profit. Of course, when selling short options the risk reward consideration is turned on its head – the maximum profit is achieved if the option expires at zero. But if the trader gets the direction wrong the potential loss is, in theory at least, unlimited since the market could keep going up and up, whereas the lowest price the market can get to is zero.
Due to this, if you are selling options then it is imperative that you monitor your positions very closely.
David Jones is the chief market strategist at IG Index.
For further information on slightly more complex strategies there is a short online video entitled “Trading Volatility” that you can access through the seminars section of the IG Index website www.igindex.co.uk.