Options Spread Betting Basics

Some spread betting firms like ETX Capital, CityIndex and IG Index will allow you to spread bet in equity and index options - although these are only appropriate for the more experienced as this is probably the most complex form of financial spread betting.

  1. An option gives you the right, but not the obligation, to buy or sell a security at a fixed price on a specified date. Fixed price is referred to as strike price and the specified date is also known as the expiration date.
  2. A call option gives you the right to buy a security at a fixed price. A put option, on the other hand gives you the right to sell a security at a fixed price and here you are speculating that the market will fall. It is important to note that you are not obliged to exercise the option - if the bet works out you can cash it in but if the option goes wrong usually you are free to walk away losing nothing more than the premium you paid for the option.
  3. Option contracts have prices which are typically a small fraction of the price of the underlying. For example, with the FTSE index at 5500 in mid September a Call option with a strike of 5750 expiring in December might have a value of 120.
  4. The price of options depends on several factors:
  5. The time to expiration (every day that passes diminishes the value of an option other things being equal - as the option only has value up until its expiry date). Being correct in your prediction after the option has expired won't serve you any good.
  6. The difference between the strike price and the current market price of the underlying security (the smaller the difference, the more likely that the option will end in-the-money). This is referred to as the 'intrinsic value' of the option.
  7. Volatility (the higher the volatility, the more likelihood that at some point the option will reach its target price - hence greater volatility usually attracts a bigger premium). For this reason it is better to buy options when volatility is low, but rising or likely to rise.
  8. Interest Rates (like futures the price will reflect the financing cost). However, the effect of changes in interest rates is insignificant relative to the more influential effect of changes in volatility.
  9. Dividends (option holders are not entitled to dividends so this is compensated for in the price).
  10. The most variable factor in the determining of an option's price is volatility which is measured in standard deviation. This is independent of what has happened in the market in the past but depends on how volatile the market is expected to be in the future. The higher the volatility, the higher the premium and volatility will usually be highest just before results announcements or if bid or merger rumours are circulating.
  11. Buying options tends to be expensive - whilst a small move in the futures market could be enough to make you substantial gains, you will need bigger moves on an options trade to finish in-the-money. For instance if you were to go long on a FTSE 100 future spread bet and the index moves higher then you are likely to make a profit. Whereas if you were to buy FTSE 100 call options and the FTSE 100 rises, then it might still be possible for the trade to lose money if the FTSE doesn't finish sufficiently higher. In particular, the hidden costs of front running can kill you (the USA option exchanges can be particularly crooked...at one point, high frequency traders got to jump to the front of the queue).
  12. Buying options can be a good way to take a view on a market whilst having only limited downside, as the maximum possible loss is limited to the price paid for the option. Selling options is however much riskier since by selling options, you are essentially accepting a limited possible profit (the price you sold at) whilst exposing yourself to potentially unlimited losses. Once you have bought or sold the option of your choice you are free to run that option to expiry, or to trade out of the position at any time.
  13. It is important to note that options can be highly complex and suitable only to experienced investors. If you aren't a professional then its best to leave complex combination option trades alone and stick to plain puts and calls. Although they can be handy in many cases traders (and not only traders but also some renowned investment banks and hedge funds) end up losing money using these instruments.

Using Spread Bets to trade the Options Markets

  1. Spread betting in equity and index options is not subject to capital gains tax on profits, whereas option trading in the traditional way attracts taxable gains and losses. Another important consideration is that it is possible to trade in much smaller sizes in options when using spread betting; the size of a spread bet being determined by the size of your stake (as opposed to the size of the option contract). To take this into perspective consider that a FTSE index option may have a value close to £50,000 (10 times the index value expressed in pounds). An index option priced at 500 involves capital at risk of £5000 in the conventional option. A spread bet on an option priced at 500 at £1 a point involves capital at risk of 'just' £500.
  2. Note also that no extra gearing is involved when spread betting on options. The difference between spread betting on options and normal spread bets on equities or indices is that the NTR (margin) required to be deposited to open a position is always equivalent to the full value of the option price which means that options traded through spreadbets are no more risky than those traded the traditional way.
  3. Option spread bets work in a very similar way to exchange-traded options. Spread betting companies typically quote options on the major market indices, individual equities in the FTSE 350 and commodities such as gold and silver. Buying (as opposed to selling) option spread bets offers a limited risk way to access price movements.
  4. Stock market index options are the fastest growing sector in this field and most spread betters buy calls or puts depending on whether they believe the market to go up or down.
  5. A spread bet option usually takes the form of a spread market on an underlying exchange based option contract.
  6. Sometimes you may need to phone the spread betting broker as the prices for certain option markets may not always be available online.
  7. It is important to note that when using spread bets to trade the options markets buyers and sellers are not locked into a contract until the expiry date.
  8. Remember that the more time is left to expiry, the greater the cost of an option. This clearly implies that the time value of an option decays as the expiry draws closer. This decay of the time value does not occur uniformly, however. The rate of decay increases as an option approaches expiry. The passage of time is detrimental if you are long (have bought) an option: every passing day means a decrease in the value of your option, all other things being equal. The passage of time is beneficial if you are short (have sold or written) an option.
    Spread Betting on Options
  9. Buying straight calls or puts is usually more practical than using combination strategies such as 'writing covered calls' or 'straddles' (mentioned above) especially when using spread betting as it's slightly more expensive to spread bet on options than it is to trade them directly.
  10. The attraction of buying calls or puts is that your risk is always limited to the premium. Selling puts or calls is riskier but here you are taking the view that the spread betting brokers' quotes are too biased.
  11. Using 'calls' or 'puts', you can place up or down spread bets on the quoted prices whilst knowing your maximum downside risk without limiting your upside profit potential. This is because the maximum that you can lose is the premium that you paid at the outset.
  12. Options are less risky than futures trades but tend to be more expensive. Only trade options if you expect medium to big sudden moves. A futures bet is usually more appropriate if you expect small or gradual moves in the market. Bear in mind that the moves here have to be quite large for options to be cost-effective.
  13. Remember that spread bet options are always cash settled - when you trade with a spread betting firm no options actually change hands - you are simply betting on price changes. You therefore cannot exercise an option with a spread betting company. You can choose to close your deal at any point against the current price the spread broker is making for that option, or simply leave the option to expiry at which point your position will be settled against the value of the option as defined by the price of the underlying at the expiry point.
  14. Beware UK options. The spreads tend to be wide and these will reflect in the spread betting quote. Also, option market spreads on lower price options tend to be wide and spreadbetting on options involves an extra spread on top which makes it harder to make money. This means that you will need a much bigger move on an options trade to finish in the money than futures trading.
  15. When trading options via spread bets its worth checking out the different providers if you intend to hold the option till expiry because sometimes the prices are quite a bit off each other.
  16. You don't have to trade the Vix to acquire exposure to market sentiment; you can also trade options. This is because when volatility is high, then options prices tend to rise and vice-versa. In fact, it might be better to stick with trading options on big stock indices such as the FTSE 100 rather than individual stocks, since volatility seeks to reflect overall market sentiment. You can also trade forex pairs, for example US dollar-sterling, euro-US dollar and US dollar-yen, which are very sensitive to risk appetite.

>> Call and Put Options - Examples

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