The ins and outs of trading options

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The rise of CFDs and spread betting has tended to mean investors have increasingly ignored other, more traditional means of gaining leveraged exposure both to the market and to individual shares. Chief among these more traditional methods is trading options.

Trading options to buy (calls) and sell (puts) the market or an individual share has been around in the London market since the late 1970s. LIFFE (now EuronextLIFFE, and part of the NYSE) has always struggled to attract large numbers of private investors to the market, despite extensive marketing. In part that is due to the apparent complexity of options, and option pricing. Transaction costs are also probably higher on balance, or at least more obvious, than those on products like spread bets.

Options do, however, have one big advantage.

Unlike CFDs and spread betting, losses on options are not unlimited. Option buyers can only lose, in the worst case, the amount they invest. This contrasts to CFDs and spread bets where, if stop-losses are not used, losses can be substantial and theoretically unlimited. Yet options have substantial leverage if the option buyer's judgement is correct and the price of the security underlying the option moves in their favour.

In addition, leverage in options can be controlled by the buyer, by means of the nature of the option series he or she chooses. 'Out of the money' options - where the market price of the underlying is below the exercise price of the option (in the case of a call) or above it in the case of a put option - are cheaper but more volatile, because they have would have no intrinsic value if the price was unchanged on reaching expiry. 'In the money' options, those which could be exercised at a profit immediately, are more expensive, but inherently less likely to see volatile price movements.

The drawbacks to trading options rather than using other methods of gaining leverage include the complexity of the range of influences over their price.

Apart from the obvious fact that the price of the underlying security, share or index has a large bearing on the option price, interest rates, where the underlying price stands relative to the exercise price of the options, volatility in the price of the underlying security, and the length of time to go to expiry all have a bearing on the way an option's price moves.

Underlying volatility and time to expiry are particularly crucial and often overlooked by novice option traders. By definition, anything other than the intrinsic value (if any) of the option disappears on expiry, and decays progressively the near the expiry date gets. In this sense, an option is a 'wasting asset'. Underlying volatility affects option prices directly. Higher volatility means higher option prices, other things being equal, and vice versa.

Traders therefore need to have reasonable confidence that any view they take when they buy an option will bear fruit inside a reasonable timescale, so that the time decay in the option does not offset any profits they might otherwise have made. The longer the option has to go to expiry the less importance this factor assumes. Avoiding buying options when volatility is high is also a sound approach.

One big plus point for option traders is that it is possible to model likely price movements accurately using simple option pricing software that can either be downloaded or accessed online.

Using software like this, assumptions can be made about underlying price movement, volatility levels, and about how long a strategy might take to bear fruit. The option price level produced by the model under these assumptions can then be compared with the current price of the option to determine the profit potential of the trade, which can then be executed with greater confidence, or discarded if the margin of safety is insufficient.

For a look into how certain software can help your decision-making process, read: Specialist software to aid your investing.

Before trading in options, would be investors need to open an account with a specialist option broker and deposit funds to cover their trading, but in this respect options are no different for spread betting and CFDs. Dealing spreads on low-priced out of the money options can be sizeable, however, and this needs to be factored in calculations of any profit potential a trade might have.