Not for everyone, but still growing in
Mention Option trading to seasoned investors and you'll get the
same reaction you get from a plumber when he's about to quote you a
price! A shake of the head and a sharp intake of breath is the
normal reaction when a retail investor enquires about option
markets. This is because many believe these are complex and
advanced products that are more suited to the professional and
institutional market place. In some cases this is true, but as with
any financial product if the market and product is researched the
risks can be understood and more importantly reduced.
What is an option?
The definition of an Option, as quoted on Wikapedia, is a
contract between two parties concerning the buying or selling of an
asset at a reference price. The buyer of the option gains the
right, but not the obligation, to engage in some specific
transaction on the asset, while the seller incurs the obligation to
fulfil the transaction if so requested by the buyer.
Phew, sounds complicated. How does it work in
Option trading is actually simpler than it first appears.
Let's look at an example using the gold market and better
understand how options actually work.
If gold is trading at a price of $1500 and Trading.co.uk wants
to hedge exposure to the price of gold moving above a price of
$1550 it may wish to take out an option to buy Gold if the price
rises above this level.
This 'reference price' or 'strike price' of the option is the
level that both the buyer of the option (Trading.co.uk) and the
seller of the option (the Market Maker) agree to form part of the
contract. The seller of the option requires the buyer to pay a
premium for the hedge (or think of it as insurance) and so sets a
level of the premium that both the buyer and seller are happy
In this example let's suppose the seller and the buyer agree on
a $5 premium which means that the buyer won't begin to make money
from the trade until the price rises above $1555 and the seller
won't begin to lose money if the price doesn't rise above this
Clearly the seller of the option has unlimited risk. If the
price of Gold rises to $1650 he is liable for every dollar move
above $1555 so would be faced with a loss of $95 times the buyers
chosen stake. If the price of gold never reaches the strike price
of $1550 the buyer loses the whole premium paid ($5 in this
example), but he cannot lose more than the premium paid.
Tip: Buyers of options, calls or puts, always
know the downside risks. You can't lose more than the premium you
pay but your profits are unlimited.. Sellers of options have the
opposite relationship, they can only win the premium they sell but
their losses are unlimited. Selling options is one of the
more risky ways to trade the market and not for those who are new
to these products.
Why on earth would you want to sell an option?
So what's the appeal of being an option seller? Unlimited
downside and limited upside doesn't sound like a great deal.
That is until you read that most options expire worthless and
that historically it is the sellers of options who make money.
It's a bit like an insurance company collecting premium from
householders to insure their personal effects. Most individuals
will never claim on their insurance policies but like to know that
if the worst happened they are covered. Occasionally something
terrible happens in a part of the world that means insurance
companies have to pay out hundreds of millions of pounds in claims.
Often they have re-insured some of their risk with other firms so
that they are able to settle every claim in full.
Fast moving markets result in volatile options prices.
Go back to 2008 when the markets went into meltdown during the
banking crisis and as an option seller you would experience
something akin to the catastrophe insurance claims described
The markets went into free fall and so all of the option buyers
who were insuring against the market falling would be very quickly
in profit. Selling options can sound like a good idea but
understanding how quickly things can move against you is incredibly
important and ensuring you have enough capital to undertake such
activity is obviously a definite requirement.
Tip: If you do intend to sell options make sure
you have plenty of capital to support your activity in the market.
It's a bit like betting on long odds on shots in sports or
horse racing, most of the time they win but occasionally you see a
freak result and the outsider comes in. It's at those times that
you need to have enough capital to absorb the losses
and continue trading.