Buying options means you always know your
A buyer of a call or a put option expects the
market to rise or fall above or below the reference
or strike price. When you buy an option you pay a premium but this
represents the maximum loss you can make.
A seller of an option does not expect the market to go
above, or fall below the reference or strike price.
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.
How are options priced?
The premium you will be charged for a call option will
depend on a number of factors. How long do you want the
contract for? Clearly the longer the timeframe the more chance
there is of the market reaching and going above the reference
or strike price.
The second is how close the strike price is to the current
market price. For example, if gold is trading at $1640 and a
call option buyer is looking for a 3 month option with a strike
price of $1650 the seller of the option (for every buyer there has
to be a seller) is going to want to charge a hefty
premium as the chances of the market rising above $1650 any time in
the three months are quite high.
The other element to be considered before the premium is set is
the relative volatility of the underlying market.
Options trading on volatile markets such as oil will have higher
premiums as extreme market movements are likely during times of
civil unrest in the key oil producing areas. Options on less
volatile markets such as interest rate futures will result in lower
premiums paid for option buyers.
Experienced options traders will often use strategies to reduce
their risk to the market by buying and selling combinations of
calls and puts.
You may have read about Iron Condors, Butterfly and
Calendar spreads, Monte Carlo strategy, long and short call or long
and short put options. Many of these are complex strategies that
also require the trader to take a position in the underlying market
as well as the options associated with it.
Understanding options and options strategies takes time and so a
good grounding in the basics of these products is essential before
moving on to the more advanced trading techniques.
Tip: If you are keen to look at trading options
and employing different strategies to reduce your risk we recommend
that you attend a training course or webinar specifically on
this subject. Option trading can be profitable but it is not
without risk. Go at your own pace and make sure you fully
understand both the strategy and, as importantly, the potential
volatility of underlying market you are trading.