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How do options work in trading?


To want to use options you must have a longer-term view of where you expect the market to be heading. I always advise guys coming through my courses – when we get to options – to buy options, as this way you limit any potential loss from day one. Another advantage of buying options is you do not have to micromanage the risk.

Although it is best to buy options it does not mean you have to be long the market. There are two main options types: call options, as a buyer of the option you expect the market to trend higher, and put options, as the buyer you expect the market to trend lower.

An option provides the buyer the right but not the obligation to accept the position. Options are valued off the underlying contract which if using the traditional exchanges is the futures contract.

The key elements of options trading

  • Strike price: the market price used as the basis of the option contract
  • Premium: The cost to the buyer for limiting his loss
  • Volatility plays a major role in the premium of an option along with duration. Higher volatility will increase the premium as will a longer duration.
  • Options are available in duration from hours to months.
  • Traders that trade options as a business are fixated on the ‘Greeks’, gamma, delta, vega and theta, as they use these to provide the intrinsic value of options.
  • At expiry, the option will be abandoned if the strike price is against the buyer or exercised if the strike price is favourable.

Options strategies: straddles and strangles

There are many strategies that can be generated by trading options. The two I favour most are straddles and strangles. These are useful at times of high volatility, especially if you feel the market is due for a big move but uncertain of the direction! They both include call and put options, which provides you with a long and short position in the same contract with the same expiry. The key difference is a straddle will use the closest strike price for both (At-The-Money) whereas the strangle will use strike prices further away from the current market (Out-of-The-Money), which is favourable for the seller, as although he receives less premium, the market has to move further before the buyer will be in profit…or In-The-Money. The buyer of the strangle will do this to reduce the cost of the premium.

As the buyer of the option the maximum you can lose is your premium. I always describe this as like taking out an insurance policy, it’s just in case! With options, it’s just in case your view is wrong!

Once I am in the money (ITM) options become interesting. I like to use the futures to hedge my options positions.

A worked example:

  1. Gold currently trading $1903.2
  2. Strike price (ATM) $1900.0 as nearest.
  3. Buy a December call option for $1.4 premium, this would be $1,400 in real money as $10 per tick (pip).
  4. My break-even level is $1901.4 calculated as $1900.0 plus the premium of $1.4 Anything above $1901.4 is a potential profit.
  5. When I consider the market is preparing to turn, I hedge my option position by selling the futures contract.
  6. Each time the market drops I buy the futures back and each time it rallies I sell again. It is possible to make substantially more from the futures hedging than the premium paid out!

Options are useful; however, the key is you must be right and ITM at least once before expiry to benefit from them.

Selling options has unlimited risk and requires constant monitoring to manage the risk. Trending markets or static markets are preferred to ranging ones, although it depends on the strike price!

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This article does not constitute investment advice. Make sure you do your own research or consult a professional advisor.

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