What is an option?
There are two basic types of option: calls and
puts
- A call option confers the right, but not the obligation, to buy
a given asset at a fixed price (known as the strike price) on or
before a given day (the expiry date).
- A put option confers the right, but not the obligation, to sell
a given asset at a fixed price on or before a given day.
When trading options you would buy a call
option if you expected the asset to go up in value, and you would
buy a put option if you expected the asset to go down in value. In
both cases, because you are buying an option, your maximum loss is
limited: you can lose only your stake multiplied by the option
value.
For example, if you bought an option valued at
20 for £10 per point, then your maximum risk would be £200 (20 x
£10). An option can never have a negative value; it can only become
worthless.
Note that spread betting on options works
differently to spread betting on equities, indices, currencies or
commodities, and can appear complicated.
Option pricing
Every market has a range of strike prices for
both calls and puts. The value of an option is dependent on the
length of time that the option has to run (its time value), its
volatility and its intrinsic value.
Intrinsic value is a measure of the underlying
price of the asset compared to its strike price. For example, if
you bought a call option with a strike price of 2,000 and the
underlying market stood at 2,200, then the intrinsic value would be
200, as the option is ‘in-the-money’ by 200 points. Likewise, if
you bought a put option with a strike price of 100 and the
underlying market stood at 80, then the intrinsic value would be
20.
Time value refers to the value associated with
the length of time an option has before it expires. The longer
the option has until it expires the greater its time value. This is
because the probability of a particular option being in-the-money
on expiry is greater if it has, say, three months to run rather
than one.
Volatility represents the value associated
with the volatility of the underlying market. The more volatile the
underlying market, the more expensive the option will be.
At expiry, time value and volatility will be
zero, so the option will expire either worthless or with intrinsic
value.
Selling an option
As mentioned above, opening a position with
Finspreads by buying an option (whether a call or a put) gives you
limited liability. Your maximum risk will be your stake multiplied
by the option value. And you can close your position by selling
before the option expires.
Selling call or put options to open a position
would give you a completely different risk profile. By selling
an option your potential profit is limited to the stake multiplied
by the option value, while your loss is potentially
unlimited. When selling options, you would sell a call to
profit from a falling market, and sell a put in order to make money
from a rising market.
Selling options carries
extremely high risk and suitable only for very experienced
traders.
See our worked example on how to place a bet on our
option markets.
Please remember spread betting is leveraged
and can result in losses quickly exceeding an initial outlay. It’s
not suitable for everyone and you should make sure you fully
understand the risks involved. If you have any doubt, please seek
independent advice.
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