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Traders use options trading to speculate on the prices of financial instruments. The technique, first used in ancient Greece, has never been old. Back then, merchants could use “halters” to lock in a price for olive and wine in production. Doing so enabled them to hedge against future price increments. The halters were enforceable contracts written on papyrus. But that was in the 17th century. Over time, this concept evolved and developed into the options trading we know today. It continues to be integral in finance, with traders worldwide using it.
But enough of history, what is it, how does it work, and how can a beginner like you buy and exploit it in the UK? Of course, there are a few terminologies you need a solid grasp of before we can walk you through them. It’s a maze, and knowing them lets you understand the whole concept.
In This Guide
What is Options Trading?
Options trading involves buying and selling agreements that set the future prices of assets. However, the contract doesn’t obligate the holder to buy or sell, regardless of the type of options they hold.
You have two types of options: the call and put options. Holding the ‘Call Options’ gives you the right but not compelled to buy the asset at the predetermined price. On the other hand, if you have the ‘Put Options’, you are assigned the right with no obligation to sell the asset at the predetermined price.
In other words, options allow you to speculate on the direction of an underlying asset. It will enable you to control a large position with just a fraction of the price.
On exchanges, options contracts are standard with terms set by the exchange, including:
- Underlying asset – the security subject to the contract.
- Strike price – the agreed future asset trading price.
- Expiration date – when the option contract expires.
- Premium – the amount you pay for the option contract.
Once you buy the option, we say it is ‘in-the-money’ if your price movement prediction is correct. That’s to say, for a call option, the stock price has surpassed the strike price, or the price is below it for a put option. However, it’s ‘out-of-the-money’ if it has no intrinsic value. Since the assets are time-bound, their value reduces as they approach expiry. The rate at which this happens is ‘Time decay.’ Another common term is ‘Implied volatility’, which measures the market’s expectations for future price fluctuations, with higher volatility leading to more expensive options.
Read about the best options trading platforms UK in our other guide.
How does Options Trading Work?
To understand what options trading is and the concepts of how it works, take this example:
Imagine you have bitcoins worth £5,000 and believe the digital currency will be worth much more. Your friend wants the right to buy your crypto holdings but is not yet ready to commit. So, he offers you a payment today, say, £500, for the right to buy your holdings at a set price of £6,000 any time within the next three months.
The £500 your friend paid is the ‘premium,’ and the agreement you and your friend created is a ‘call option.’
If the bitcoin price rises even higher than £6,000, your friend can exercise his right to buy your holdings for the £6,000 you agreed. He will benefit from the lower price. However, if the price drops or doesn’t significantly rise as he expected, he can choose not to buy the crypto. But you’ll retain the £500.
Still on your £5,000 holdings, suppose you wish to sell them in the future but are worried the price will drop. You can pay the person you intend to sell the cryptos to a premium for the right to sell them at, say, £4,950. If the price falls under £4,950, you can exercise your right and sell the spices at the higher agreed price. But if the price remains stable or rises, you can let the option expire, losing only the premium paid.
But this is just a hypothetical example, but it happens in the exchange market. If you believe a stock’s price will increase next month, you can buy call options instead of the stock itself. These options have a specific price and date when they expire. If the stock goes up like you thought it would, you can profit, even if you never bought it.
Simply put, options are more like insurance. As a buyer, the Call Option gives you the right to buy but not the obligation to do so. And if you are a seller, the Put Option gives you the right to sell but not the obligation to. If things go your way, you can exercise the option and benefit. If not, you limit your loss to the premium you paid. That drives the point home.
How to Trade Options UK: Step-by-step Guide
Options trading could be a good option, but you should take it easy, as risks are involved. Below are some step-by-step guides to help you get started.
Step 1: Assess yourself
Step 2: Choose the option broker
Step 3: Choose your underlying market
Step 4: Set the rules for your trades
Options are riskier than stocks as they have complexities that stocks do not. Before trading options in the UK, learn what you want to trade and when to apply different strategies. Take options trading courses and review contract details thoroughly. Missing an expiry date, choosing the wrong options, or not understanding the risks can be costly. You must understand the market trends, preempt future movements using the indicators, interpret data, and understand volatility. All that requires you to check your financial position and risk tolerance and understand the volatility of options.
Since options are traded in the exchange market, you can’t trade them directly. You need a broker to do that. You must first pick a brokerage platform that fits your specific needs. Look for one that offers options trading services and consider these essential factors:
- Costs and Fees: Compare trading fees, commissions, and other charges.
- Platform and Tools: Evaluate the trading platform for usability and available tools.
- Options Availability: Ensure a wide selection of options contracts and markets.
- Customer Support: The quality and the responsiveness of customer service.
- Educational Resources: Look for educational materials to improve your trading skills and knowledge.
In options trading, you access various asset classes, including Foreign Exchange (Forex), Stock Indices, Individual Stocks, and Commodities. For Forex, you can trade major currency pairs like USD/GBP, EUR/USD, and JPY/USD and exotic pairs such as EUR/MXN or TRY/JPY. For stocks, you can trade based on the performance of major indices like the FTSE 100 in the UK, the S&P 500 in the US, and the DAX in Germany, as well as individual stocks. Commodities include essential goods like oil and iron ore (hard commodities) and agricultural products like wheat and soybeans (soft commodities), vital in everyday life.
Most broker trading apps let you set these rules and automatically implement them. They include:
- Stop-loss orders to sell if the trade goes against you by a set amount
- Take profit orders to sell once you’ve hit your profit goal
Options Trading Risks in the UK
We don’t talk about investment without mentioning risk; the bar is a notch higher for options trading. When you trade options, you put your capital at risk, and unlike many more straightforward instruments, options are particularly complex. Many options on stock indices expire worthless. But don’t falter at the mercy of opportunity. With risk management and asset management techniques, you can make money.
First and foremost, diversify your portfolio. Aren’t we told never to put all our eggs in the same basket? It helps you spread the risk across different assets and industries. Even so, invest based on your ability and risk tolerance. Don’t put a significant amount in line that you might regret losing.
You can also utilise risk-reduction tools like the take profit and stop-loss orders. These tools are at your disposal as a broker trading feature. They help you protect the profit and limit potential losses by selling your option if it hits a set price. You can use leverage, but avoid overleveraging, as it can magnify losses, especially for beginners.
Also, being informed of what’s happening and events that affect your trades goes a long way toward rewarding you. If a company makes a product announcement, chances are the market will be excited about it. So, the price could shoot, positioning you for profit. But bad news could spell doom for your position.
Before you get deep into this, you can always open a demo account and learn the tricks. Most brokers offer up to 10,000 virtual funds to help you hone your skills risk-free. The demo trading account is modern-day paper trading to gain experience.
Remember, you trade to better your financial position, which can’t happen if you lose capital. Successful options trading is about preserving your capital as much as maximising gains. With sound risk management practices, you will successfully walk through the market.
Where Can You Buy and Sell Options?
You can trade options in the UK through several platforms, including online brokerage firms and trading apps such as eToro or CMC Markets, which provide these trading features. The London Stock Exchange (LSE) also facilitates options trading, accessible through brokers offering LSE trading. Financial advisors and investment firms in the UK can also offer options trading services, providing expert guidance and trade management.
Pros & Cons of Trading Options
Pros:
- High Returns and Leverage: Options can deliver significant returns over a short period due to leverage, allowing a small investment to multiply quickly.
- Volatility and Potential Gains: Options prices are more volatile than stock prices, offering opportunities for substantial gains.
- Low Commissions and Liquidity: Major brokers offer reduced or no-cost options trading, and options are liquid, allowing for quick cash exchange during market hours.
Cons:
- Expiration: Your investment prediction must be correct within the option’s timeframe.
- Potential Losses: Options prices fluctuate significantly, risking rapid declines in investment value.
FAQs
What is implied volatility in options trading?
Implied volatility measures the market’s expectations for future price fluctuations of the underlying asset.
What is the difference between American and European options?
You can exercise American options anytime before expiration; that can only happen at expiration for European options.
Can you start trading options with $100?
You can start trading options with $100, but your trade choices and potential strategies will be limited.
Are options a high-risk investment?
Yes, options are considered high-risk investments due to their leverage and potential for significant price volatility.
Conclusion
Options trading puts your money to work in the market with distinct risk and reward profiles. While stocks offer high-risk, high-reward potential, options amplify this, with the possibility to double or triple your investment—or lose it all—often within weeks or months. Options present drastically different returns and risks, so it’s crucial for investors to understand how they work before getting involved. Though stocks are risky, options can be even more dangerous.
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