Benefits of options trading

Advantages of options

Historically, options have been used in various cultures to secure the price of goods or commodities for future delivery. Key potential advantages of options trading include:

• Variety of strategies: whatever your trading style, options provide a range of strategies to cater to different risk profiles and market outlooks.
• Risk mitigation: know your potential loss up front. When buying a call or put, the maximum loss is limited to the premium paid for OTC options, or the option price multiplied by the stake amount for spread bet options.
• Use of leverage: trading options with leverage allows traders to gain greater exposure to an instrument by committing a pre-determined percentage of the trade’s full value, known as margin requirement. Leveraged trading can amplify both gains and losses. If you choose to go long on options with us, you’re required to put up the full premium as margin for our OTC options (with spread bet options, the margin is equal to the option price multiplied by the stake).
• Speculate: options enable traders to profit from a range of price movements in the underlying asset, whether rising, falling, or remaining flat.
• Hedging: by trading on options, investors can protect their underlying stock portfolio investment from adverse price movements through hedging.

Variety of strategies

Options trading offers a range of strategies. We look at four popular options trading strategies, shedding light on how they work and their potential benefits.

Cash-secured puts

Cash-secured puts involve selling a put while simultaneously setting aside the funds to purchase the asset if its price drops below the option’s strike price.

If the underlying asset price stays above the strike price, the put option will expire worthless. With OTC options, you’ll keep the premium paid (for spread bet options, you’ll keep the equivalent of the option price multiplied by the stake). If the asset price falls below the strike price, you’ll be obligated to buy the asset at the strike price, but you’ll retain the premium, or its equivalent.

For cash-settled options, instead of receiving the underlying asset, you’re paid a cash settlement based on the difference between the strike price and the underlying asset price.

This strategy allows you to take advantage of market stability, or to potentially buy a stock at a lower price, while keeping the premium paid with OTC options (or its equivalent for spread bet options).

Covered calls

Covered calls are a strategy where you hold a long position in a stock and sell (write) call options on that stock. With OTC options, you earn a premium from selling the call (with spread bet options, you earn the equivalent of the option price multiplied by the stake).

This strategy provides an income stream on top of any dividends or gains from the stock, but limits the upside potential.

Short strangle

Short strangle involves selling an out-of-the-money call and an out-of-the-money put on the same stock with the same expiration date.

When you sell an option, you receive a premium when trading OTC options (or the equivalent of the option price multiplied by the stake with spread bet options). In a short strangle, you collect this from both the call and the put options you sell. The total income you receive from selling these options is known as the "premiums collected".

The maximum profit in this strategy is limited to the premiums collected with OTC options (or the option price multiplied by the stake with spread bet options), because once you've sold the options, the most you can gain is the income from these amounts. There's no other source of profit in this position.

This maximum profit is realised if the stock price stays between the strike prices of the call and put options until expiration. In this scenario, both options expire worthless, and you get to keep the entire premium with OTC options (or its equivalent with spread bet options) as profit. Losses can occur if the stock moves significantly in either direction.

You can profit in a neutral market if the stock stays between the two strike prices. It's a strategy aimed at generating income in range-bound markets.

Long straddle

A long straddle involves buying both a call and a put option on the same stock with the same strike price and expiration date. You profit if the stock moves significantly in either direction. The maximum loss is limited to the combined premiums paid with OTC options (or the combined option prices multiplied by the stake for spread bet options).

This strategy allows traders to profit from big price swings, whether upwards or downwards. It's a bet on volatility rather than a specific price direction.

These are just a handful of strategies available in options trading. Each has its own nuances, based on specific market conditions and trader objectives. As with all trading methods, it's important to make sure that you understand each strategy and consider your risk tolerance.

Managing your risk

Options are used by some traders as a means of mitigating risk.

Defined risk: when you buy an option, your potential loss is capped at the premium you paid with OTC options (or at the option's price multiplied by the stake for spread bet options). However, it’s worth noting that you could lose more or less than this amount, for example, if you're trading in different currency to your account currency, due to FX price fluctuations and a currency conversion fee. The option will expire worthless if the market doesn't move enough to be in-the-money, so if you have multiple option positions that aren’t in-the-money, your overall losses will accumulate.

Flexibility: options provide the ability to profit whether the market is going up, down, or staying flat. This presents more potential opportunities to profit and diversify.

Hedging: by trading on options strategically, you can protect your broader investments from adverse market movements. Learn more about hedging below.

Hedging

A long put option can be used as a type of insurance against a drop in the price of an asset you already hold a position in. Using options to hedge can reduce short-term risk and limit any losses.

You may be able to buy a put option directly on the asset you hold, or on an index which is closely correlated to your portfolio, known as a proxy hedge. The goal is to offset any losses that may occur in your portfolio if there are adverse movements in the underlying market.

Example of options hedging

Your investment portfolio includes an investment that tracks the S&P 500, which is currently valued at $4,000. After a news announcement, you identify the risk of a potential market downturn that could negatively impact the value of your portfolio.

You decide to mitigate this risk by purchasing a European-style cash-settled put option on the S&P 500 index. The strike price of the put option is set at 3,900 points, with an expiry date three months from now.

The contract stipulates that if the S&P 500 index falls below 3,900 points by the expiry date, it will automatically exercise your right to receive a cash settlement for the difference between the strike price and the underlying asset price of the S&P 500. This ensures that if the S&P 500 remains above 3,900 points, the option will automatically expire worthless, resulting in a loss – limited to the premium paid for OTC options, or the option price multiplied by the stake, for spread bet options.

If the S&P 500 falls below the strike price of 3,900 points, the contract will be exercised on the expiry date, and you will receive a cash payment corresponding to the difference. This payout will help offset any decline in the value of your investment portfolio tied to the index's performance.

This put option trade means you’ve protected your portfolio against the adverse effects of a declining market, ensuring a measure of stability and risk mitigation.

Options differ from a standard stop-loss order, which is triggered automatically at a predetermined price level, though the execution price can differ from the trigger level in volatile markets. Options provide the flexibility to exit the trade based on market conditions up until the expiry of the contract, offering a strategic advantage in managing market exposure.

Risks and challenges of options trading

Trading options involves speculating on an asset to move in a particular direction within a specific timeframe.

If the underlying asset doesn’t perform as expected within the stipulated timeframe, and the contract is left to expire, particularly with long options, the premium paid for OTC options (or the option price multiplied by the stake for spread bet options), is lost. While the individual loss may not be significant, repeated occurrences can lead to an accumulation of losses.

There is also a risk of external factors affecting an option’s value, including volatility, which will affect both long and short options. Higher volatility increases the value of long call and put options, as it raises the likelihood of substantial price movements, making these options more valuable due to their greater potential for profitability.

Conversely, for short call and put options, high volatility heightens the risk, as it increases the chances of significant price swings in the underlying asset, making it more likely the options will be exercised against the seller, potentially leading to a loss.

On the other hand, lower volatility decreases the value of long options, as the expected price movement of the underlying asset is less dramatic. However, it benefits short options by reducing the risk of the option being exercised, ultimately favouring the seller's strategy of options expiring worthless.