Options & trading options: everything you need to know

Stock options allow traders to act on their view of the future price of an asset without having to commit to the trade. Like all leveraged trading there are risks, but understood and used properly, call and put options can be useful. Financial, or stock options give you the right, but not the obligation, to buy or sell a security such as stocks and shares or a commodity at a set price and on a set date. 

For each option there is a buyer and a seller. The buyer is long on the option (they believe it will rise in price), while the seller is short (they believe the price will fall).

In general, the price of the option is determined by five factors:

• the price of the underlying asset
• the option’s strike price (the price the asset will trade at)
• the time to expiry (when the option must be used by)
• prevailing interest rates
• volatility in the market.

Like shares and futures, trading options takes place on an exchange. This means they will come in specific packages. Traders who want something more bespoke can create a similar effect using contracts for differences. 

Calls give the option to buy a specified amount of an asset at the strike price at some point before the specified expiry date. If they choose to exercise the option, the seller must produce the goods and sell them to the buyer at the agreed price.

Let’s say an investor agrees an option contract, buying a call option on 1,000 HSBC shares at a strike price of £450, expiring in three months. They will pay the seller a small premium, say £20, for that option. As the price of HSBC shares rises, the option to buy at a lower price becomes more attractive. If the price hits £500, for example, the buyer will exercise the option and at that point, the seller is obliged to sell their holding of shares to the buyer for £450 each. The seller has made £20 but has missed out on the growth of the shares.

A put is the option to sell the underlying stock at a predetermined strike price until a fixed expiry date. In this case the buyer must acquire the shares if the option is exercised. In our example, the investor may want to ensure that they can sell at a given price in the future, limiting any losses. They would buy a put option giving them the right to sell at, say, £420. The seller would have to buy at that price, even if the market price is far lower.

Options can carry a great deal of risk. Traders are not obliged to hold the underlying asset – known as ‘uncovered’ options (if they hold the assets the call is said to be covered). This can lead to a trader having to buy the asset in the market to meet their obligations, creating the potential for significant losses.

In our example the option seller needs to deliver 1,000 HSBC shares for which they receive £45,000 (1,000 x £450). If the price for the shares has risen to £500, they need to find £50,000 to buy the shares – an instant loss of £5,000. Losses can occur for put options in a similar way.

One way around this is to buy offsetting options, a call and put option at the same time which can then be netted off. Relatively few options expire and see assets change hands.

If they believe Apple shares will rise, for example, they may buy a call option. If the shares rise, the value of the option increases. The only upfront cost will be the premium and any margin requirements. As with all leveraged trading, this means greater exposure for minimum upfront investment. 

In contrast, a put option will increase in value when the underlying stock price falls – the option to sell at a higher price becomes more valuable.

The seller of the option will be making the opposite bet to the buyer. In the case of a call, if the shares don’t rise, they get to keep the premium and the option is unlikely to be exercised. There are funds that have a call writing strategy specifically to generate a higher income from their holdings.

Options can also be used to hedge market falls and manage short-term volatility. For example, if a trader anticipates volatility ahead, but doesn’t want to liquidate their whole portfolio, they could buy a put option on one of the major indices. As the index falls, the value of the option contract rises (because the option to sell at a higher price becomes more valuable). This can offset some of the losses in the main portfolio. Equally, a call option can be used if they are worried about missing out on a short-term stock market rally but don’t want re-direct their portfolio into higher risk areas.

Fineco offers everything you need to trade options across global markets and currencies with a range of tools, all through a single account.