What are Options?
Options are financial instruments that give the holder the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a specific price (strike price) within a specified period (expiration date). If for example you exercise one US stock option you will receive 100 shares, this differs to a UK stock option for which you would receive 1000 shares. Below is a table summarising the effect of buying and selling, put and call options:
| Buy Call Option | You have the right (but not the obligation) to buy the underlying financial instrument at the strike price. |
| Buy Put Option | You have the right (but not the obligation) to sell the underlying financial instrument at the strike price. |
| Sell Call Option | You may have the obligation to sell the underlying financial instrument to the buyer at the strike price. |
| Sell Put Option | You may have the obligation to buy the underlying financial instrument to the buyer at the strike price. |
Options can have variations in exercise style (American or European), settlement method (physical or cash) as well as underlying assets (stocks, stock indices, futures contracts). In relation to exercise style, please see the table below:
| European-style Option | The buyer will have the right to exercise the option only at expiry. |
| American-style Option | The buyer will have the right to exercise the option at any point before expiry. |
If you exercise one US stock option you will receive 100 shares, whereas for a UK stock option you would receive 1000 shares.
Trading options with leverage?
Options can provide leverage, which allows you to control a larger position with a smaller investment. By using options, you can achieve leveraged exposure to the underlying asset. For example, instead of buying 100 shares of a stock, you can buy call options on those shares for a fraction of the cost. Trading with leverage has the potential to amplify both profits and losses.
A number of factors can drive price movements in options, including changes in the price and volatility of the underlying asset, time decay, and interest rates. These factors can all cause the option’s premium to fluctuate.
Let’s say you believe that the price of a particular stock will increase in the next month. Instead of buying the stock outright, you can purchase call options on the stock with a specific strike price and expiration date. If the stock rises as anticipated, you can profit from the increased value of the options, without owning the underlying shares.
What are the risks when trading options?
When trading options, it’s important to be aware of the potential risks. These include:
- Market risk: Options are affected by the price movements of the underlying asset. If the market moves against the anticipated direction, the value of the option may decline, leading to potential losses.
- Liquidity risk: Options can have varying levels of liquidity. When trading illiquid options, you may have difficulty executing trades or enter/exit positions at your desired prices, potentially resulting in higher transaction costs.
- Counterparty risk: Counterparty risk arises when trading options on an exchange or through a brokerage. If the counterparty (Central Clearing Counterparty for Listed Options) fails to fulfill their obligations – for instance, failing to deliver the underlying asset upon exercise – it can lead to financial losses or other complications.
- Other risks specific to options trading: These may include volatility risk (changes in implied volatility impacting options prices), execution risk (slippage or delay in order execution), interest rate risk and regulatory risks, such as changes in rules or regulations affecting options trading.
How much can you lose in options trading?
Maximum potential losses differ depending on whether you are buying or selling options:
When you buy options, losses are limited to the premium paid for the options contract as if the option expires out of the money (i.e., worthless), then the only loss is the cost of the contract (premium).
When you sell options, losses can exceed the premium received and are potentially unlimited. Since options allow you to control a larger position with a smaller investment, the potential losses are magnified compared to trading the underlying asset directly. Losses can be significant if the market moves against your anticipated direction.
Additional costs and charges
When you trade options, you could face these potential costs and charges:
Commissions: Brokers may charge commissions for executing options trades. These can vary based on the broker and the size of the trade.
Options premiums: Options have premiums that must be paid when you initiate a position. The premium is the value of the option itself and can fluctuate based on various factors.
Exchange and regulatory fees: Exchanges may impose fees for options trading and there may be regulatory fees associated with certain transactions.
Margin requirements: When trading options on margin, there may be margin requirements set by the broker which need to be maintained to hold positions.
Assignment and exercise fees: If an option is exercised or assigned, there may be fees associated with the transaction, such as exercise fees or assignment fees charged by the broker.
It is important to be aware of these potential costs and charges, as they can impact the overall profitability of your trading strategy.