In traditional trading, purchasing an option is simple. An option gives you the right, but not the obligation, to buy (call option) or sell (put option) a market in the future for a specific price.
Let’s take the commodity market for copper as an example; if the price today was $400 and you believed that it would increase in the future, you could purchase a call option that gave you the right to buy at $405. However, the option would have an expiry date attached to it, and if the price of the option dipped below $405 at the time of expiry then you would lose the premium that you paid. Alternatively if the price increased to $450, then you could exercise your right to buy at $405 resulting in a profit of $45 minus your premium.
Key Points for Options Spread Betting
- A call option gives you the right, but not the obligation, to buy a market at a given price level.
- A put option gives you the right, but not the obligation, to sell a market at a given price level.
- In spread betting, you are not purchasing a physical contract – you are betting on a price movement. In this case, your bet mimics a traditional options trade.
- The price (spread) of your option is based on market volatility, the underlying market price and time until expiry.
- The strike price is the price at which you bought or sold the option.
- When selling an option your risk is unlimited, when buying an option your risk is limited to your stake times your price (spread) also called your ‘premium’ i.e. purchasing at 70 for £10 per point = £700.
- Remember that the product is the option (call or put) and you are able to sell or buy each. You can sell or buy a call, just like you can sell or buy a put.
Options Spread Betting Example
There are two very big distinctions between selling and buying options spread betting. When buying a ‘put’, your risk is limited to your premium, i.e. if you’re buying a put option at 89 for £10 per point then your maximum loss is £890. However when selling a ‘call’ your risk is unlimited – this is explained in the example below.
’Buying’ a Put Option
It’s June 2012 and the FTSE 100 stands at 5895; you’re confident that the price of the index is to decrease rapidly in the coming months. The September 5700 is priced at 86/90 and you decide to buy the put option at 90 for £5 per point.
Your total risk from this trade is 90 x £5 = £450; as if the option expires ‘out of the money’ you stand to lose your entire premium.
Over the next few months, the FTSE 100 drops to 5550 and you decide to exercise your right to sell.
Strike: 5700 / Break-even: 5610 (strike – 90) / Closed: 5550 / Profit: 5610 – 5550 x £5 = £300
You can see from this example that when buying an option (put or call) your total risk is lower when the spread is closer to zero.
’Selling’ a Call Option
When selling a call option your risk is unlimited. This is because a stock price has no maximum value that it can increase to. If you decide to take on the right to sell, then if that particular market rallies to extremely high levels then your losses will follow suit.
In January 2013 the FTSE 100 is trading at 6135 and the March call option is priced at 6250 with a spread of 80/84. You’re confident that the index will fall and you decide to sell the call option at 80 for £5 per point. The most that you can profit from this bet is £400 (80 x £5), however your potential losses are unlimited.
As your option nears expiry, the FTSE 100 rallies on the back of a number of foreign investments and a sudden positive Eurozone outlook. By the point of expiry, the FTSE stands at 6550.
Strike: 6250 / Break-even: 6330 (strike + 80) / Closed: 6550 / Profit: 6250 – 6550 x £5 = -£1500