What is options trading? | CMC Markets (2024)

There are two main types of options contracts: calls and puts. Buying a call gives you the right to buy an underlying asset at a predetermined price when entering the options trade; the buyer of the call ideally wants the price of the underlying asset to be higher than the strike on the expiry date.

Buying a put gives you the right to sell an underlying asset at a strike price determined when entering the options trade; the buyer of the put ideally wants the price of the underlying asset to be lower than the strike on the expiry date.

A call option provides the holder (buyer) with a right (but not an obligation) to buy an underlying asset at the strike price. For cash-settled options, buyers receive a cash payment if the underlying price is above the strike price, at a specified expiration date and time.

If you’re the writer (seller) of a call option, you have the obligation to sell an underlying asset. For cash-settled options, writers make a cash payment if the holder/buyer exercises the option. Cash-settled options are exercised automatically when in the money.

Imagine that a trader expects the FTSE 100 index to rise over the coming month. The trader buys a call option at a strike price (the pre-agreed price at which an options buyer will settle the contract) of 7,500 points, expiring in one month.

The options we offer on the underlying indices have a multiplier of 1. This means that 1 option contract refers to 1 unit of the underlying index. The premium for this option is £60.

One month later when the option expires, the FTSE 100 has risen to 7,650 points. This means that the trade is ‘in the money', by £150 (7,650-7,500), and is therefore favourable to the trader.

In this scenario, the trader has generated a net profit of £90 after the cost of the premium (£60) is subtracted from the in-the-money value (£150).

However, if after one month the index settles at the same level as the strike price of 7,500 points, this is known as being ‘at the money’, where the strike price and the underlying asset’s current price are the same. In this scenario, the option would not be exercised, and the trader would therefore lose the premium of £60.

If the underlying asset price is below the level of the strike price, it’s ‘out of the money’, which is when the current price of the underlying asset is unfavourable for the buyer. The option would not be exercised, and the trader would lose the premium of £60.

Let’s assume that a trader expects the FTSE 100 index to remain stable, or slightly decline, over the coming month. The trader sells a call option with a strike price at 7,400 points, expiring in one month. The trader receives a premium of £50 for the sale of the option.

One month later when the option expires, the FTSE 100 settles at 7,350 points. In this case, the option buyer will not exercise the contract, meaning the trader, who sold the contract, gets to keep the premium of £50 as profit.

However, if the FTSE 100 settles at expiration above 7,400 points, then the buyer will exercise the contract. If the price is significantly above this level, then the seller can incur large losses. For example, if the FTSE settles at 7,500 points the contract will be exercised and the trader (the seller of the contract) will make a loss of £50.

A put option provides the holder (buyer) with a right (but not an obligation) to sell an underlying asset at the strike price. For cash-settled options, buyers receive a cash payment if the underlying price is below the strike price, at a specified expiration date and expiration time.

If you’re the writer (seller) of a put option, you have the obligation to buy an underlying asset, or where an option is cash-settled, make a cash payment if the holder exercises the option.

In this example, a trader buys a put option for the FTSE 100 with a strike price of 7,450 points, expiring in one month. The premium for this option is £40.

One month later when the option expires, the FTSE 100 has fallen to 7,350 points. This means that the trade is ‘in the money’ by £100. The net profit – after deducting the premium of £40 – would be £60.

Let’s assume that a trader expects the FTSE 100 index to remain stable, or slightly increase, over the coming month.

The trader sells a put option with a strike price of 7,500, expiring in one month. The trader receives a premium of £40 for the sale of the option.

One month later when the option expires, the settlement price is 7,520. In this case, the option buyer will not exercise the contact, meaning the trader, who sold the contract, gets to keep the premium of £40 as profit.

However, if the FTSE 100 settles at expiration below 7,500, the buyer will exercise the contract. If the price is significantly below this level, then the seller can incur large losses. For example, if the FTSE falls to 7,400 points, the trader will suffer a loss of £60 (£100 - £40 [premium received]). The loss is partly offset by the premium received when the contract was sold.

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When you trade options, you can’t attach a stop-loss order or take-profit order to your position as you might with a CFD trade or spread bet.

However, if you buy (go long on) a call or put, your maximum risk is predetermined because your potential loss is limited to the price that you paid for the option, known as the ‘premium’.

On the other hand, if you sell (go short on) a call or put, your potential loss is unlimited. Overall, you could lose all the funds you've deposited in your account. For professional clients, losses can exceed deposits.

Note: when you trade with us, options are denominated in the currency of the underlying instrument rather than your account currency. This mean that forex movements can impact overall profit or loss on a trade.

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Every option contract has what’s known as an intrinsic value. The intrinsic value is calculated from the difference between the option's strike price and the underlying asset's market price. The more significant this difference is, the more valuable the option. For example, if an index price rises, a call option on that index would gain value.

Increased volatility in the underlying asset can raise the option's price. When the underlying asset has greater price fluctuations, there's a higher chance of significant price moves, potentially making the option more valuable.

Traders can realise profits or losses by closing their positions before expiration. For cash-settled options, there's no acquisition or disposal of a physical asset, so if the option is ‘in-the-money’ at expiration, the holder receives the cash difference.

The price of a cash-settled option can be broken down into intrinsic value and time value (or extrinsic value). Intrinsic value for a call option is how much the underlying market is above the strike price. Time value accounts for the probability of the underlying moving further into the money before expiration. It’s important to bear in mind that an increase in volatility also raises the possibility of an option swinging toward being ‘out- of- the- money’ at expiration.

The two main styles of options available are American-style options and European-style options. American options can be exercised at any time before they expire, whereas European options can only be exercised in a set period just before their expiration date.

Options can be an effective way to hedge an existing position on an investment. They give you an opportunity to hedge the downside in volatile markets, without giving up on upside potential. Taking out long option positions gives you certainty over your risk, as you know your maximum loss for the position is limited to the premium paid for the contract. However, the maximum loss when selling options is unlimited.

Even if you don’t exercise an existing option, trading them can be beneficial. Buyers may pay a higher premium to secure an attractive strike price, particularly if your call option strike price is currently much lower than market value. If the market value falls, and it’s no longer worthwhile to exercise them, you’ve made a profit from the premium.

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