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Use options spread bets to capitalise on volatile markets

JUST as we thought everything had calmed down and the recovery was back on track, the markets have spent the first two months of 2010 being buffeted by events in the Eurozone, weather disruption and political uncertainty. Such volatility is unlikely to abate – there are elections on the horizon in both the UK and the US, there is still a risk that other indebted Eurozone members will follow Greece into the mire, and tensions in the Middle East are still worrying.

While volatility is often good news for spread betters, making the most of it depends on calling moves correctly – ending up on the wrong side of a trade can wipe you out. Unfortunately, many of the big themes driving the markets at that moment are not clear-cut and it is proving hard to call events.

One way in which traders can profit from these markets is by spread betting on options. These derivative products are quite complex and are normally the reserve of professional traders, but experienced retail traders can take a view on market volatility and longer-term market direction by spread betting on the price of an option. A couple of providers offer options spread betting, including IG Index and ETX Capital.

You can trade on the price of both put and call options – a call option is the right to buy a particular market (the underlying market) at a fixed level on or before a fixed date while a put option is the right to sell. It is important for spread betters to understand how the value of an option is constructed. You are betting on the change in price, and the valuation is split into two components: intrinsic value and time value. Intrinsic value exists if there is some value to be gained from exercising it – ie, if the Dow is trading at 10,400 and a call option gives the right to buy the index at the fixed price (strike price) of 10,350 then there is 50 points worth of intrinsic value. Any option that has not yet expired has some time value, which reflects the possibility that it may increase in value to the holder before expiring.

Options are beneficial to spread betters for a number of reasons. Those who want to take a directional view in volatile markets will benefit from the limited downside of spread betting on options – you will never lose any more than the initial cost of the option and you won’t be shaken out of the market by an adverse volatile move. You can also spread bet on quarterly options with IG Index, which allows you to take a longer-term directional view. However, these will cost you more because they have longer to go until expiry and if the market does not move very much, then the option will decline in value.

David Jones, chief market strategist at IG Index, says that many of IG’s clients use spread betting on options to take advantage of volatility. If you aren’t sure which way a major data release will go but know that it will move the markets a lot, then you can buy a put and a call option spread bet – a strategy known as a straddle. You can buy a straddle on the Dow with a fixed price of 10,320 for about 65 points. Providing the market moves more than 65 points (to either above 10,385 or to below 10,255) you will end up in profit overall.

Options might be more complex than other spread bets, but with limited downside and the capacity to take a view on market volatility, spread betting on options can be an excellent tool to use right now, if used conservatively.