What Are Options?
Traders can buy & sell vanilla options (contracts) of a specific financial instrument at a predetermined time, fixed price, and fixed amount. When you trade these options, you have full control over the price you’re trading at, the underlying financial instrument, and the quantity you are trading. It is possible to trade vanilla options over the course of a day, a week, several months, and a year.
Many UK traders don’t know a whole lot about vanilla options. In fact, most folks prefer trading spot options over vanilla options. Truth be told, the moment you understand how vanilla options work, they are highly enticing to trade. For starters, you have a whole range of choices available, and you can control most-every aspect of these trades. By balancing risk and reward, it is possible to enjoy access to multiple financial instruments.
Important Vanilla Options Terms
Traders need to understand certain terms before trading vanilla options. There are effectively 2 types of vanilla options:
- Call Options – with call options, the buyer has the right to purchase an instrument at a set price. Call options are purchased by traders who are bullish on the market.
- Put options, the buyer has the right to sell the specified financial instrument. Put options are typically purchased by traders who are bearish about the markets.
It is possible to buy/sell put options and call options at your leisure.
Buyers must pay sellers a premium – a specified amount to own an option. If the trader acts as a buyer of an option, he/she will pay that premium. When the trader sells that option, the trader will receive that premium. Several factors determine the premium including the price of the instrument/current rate. Since these are future-oriented contracts, the time element is important. The expiration date is known as the date at which the option can be exercised. The strike price is the price at which the option buyer can execute the trade. Options with a date in the future typically have a higher premium than options with a short-term date. Much the same is true of purchasing insurance.
Understating Market Volatility
The volatility of the financial instrument also determines the premium. When there is high volatility, the price of the option will increase. High volatility is associated with bigger market movements that can generate bigger profits. This is possible even before the option has hit its strike price. Traders can decide to close option positions at any time during the trading day. This means that you can profit from higher premiums through rising prices, or through increased volatility.
Look at the table below which illustrates how price movements on call/put options are affected:
|AN INCREASE IN:||CALL OPTIONS||PUT OPTIONS|
A Quick Lesson in Vanilla Options
When you buy a put option or a call option, you pay the upfront premium from your account’s cash balance. The potential profits are limitless. On the other hand, when you sell options, you will receive the premium upfront, and it will be deposited into your cash balance. The downside is that you may be exposed to unlimited losses if the market moves against you. This is equivalent to the losing perspective in a spot trade.
To mitigate these risks, traders have a wide range of resources available, such as stop loss orders. Other options available to you include purchasing an option further out of the money, thereby limiting your overall exposure.
When you buy options, you have limited risk. Your risk is restricted to the amount of money you spent on the premium. When you sell options (a profitable way to generate income), you act much like an insurance company. You offer protection to another trader on their position.
Once you collect the premium, the market will react according to speculative sentiment. The trader will retain the profits that he/she generated from that risk. If the trader is wrong, there is no difference to being wrong in a regular spot trade.
In any event, traders will be exposed to a potentially unlimited downside. It is possible to close out the position with stop loss orders, however with options the trader will earn the premium which is a significant advantage over spot trading.
Quick & Easy Steps for Trading Vanilla Options
- Analyse the market perspective on your underlying financial instrument. If you believe a financial instrument will rise, you can purchase the financial instrument outright with regular spot trading.
- You can also purchase a call option. When you use this strategy, the most you can forfeit is the premium which is paid upfront. You can sell this position at any time, and this is the safest way to initiate your bullish perspective on the market.
- With vanilla trading, you can also sell put options. If the financial instrument is priced higher than the strike price at expiration, the option will not have any value, and the trader will retain the entire premium that was collected upfront.
Examples of Vanilla Option Trades
Let us assume that the EUR/GBP pair is currently trading at 1.1000. If you believe that the currency pair will rise this week, this is what you can expect:
The Spot Trade: You may open a position for 10,000 units of the EUR/GBP pair. If the EUR/GBP pair appreciates, you will instantly generate a profit.
Purchase Call Option: In this instance, you may buy a call option with a week until it expires, at a strike price of 1.1020. You will pay the premium as per the trading platform – 50 pips or 0.0050. If at expiry time the EUR/GBP pair is greater than the strike price, you will earn the difference between the prevailing rate of the EUR/GBP pair and the strike price. Your breakeven level will be the strike price + the premium you paid initially. You can generate profits at any time before the expiration date of the option because of the increase of the implied volatility of the pair. The higher the EUR/GBP pair moves, the greater the profits you will generate.
Another example will clarify this further: If the pair expires at 1.1100, your option will be 80 pips in the black, otherwise known as in the money. The profit you generate will be equivalent to 80 pips less the premium of 50 pips. Alternatively, if the spot price is less than the strike price at expiration, your loss will be capped at your premium of 50 pips.
Remember, your losses will always be limited to what you paid if the spot is less than the strike price at expiration.
Selling Put Options: In this instance, you can sell a put option. This means that the trader – you – will receive the premium directly into your account. You assume a level of risk as a seller, if you are mistaken about market movements. Choose the strike price carefully. You should be comfortable with your perspective that the EUR/GBP will not move lower than the strike price at expiration.
Seen from a different perspective, you should be entirely comfortable buying the EUR/GBP pair at the strike price. If the spot price ends lower, you (the seller) have the right to exercise a put option on the EUR/GBP pair at the strike price. You will receive the upfront premium in return for taking the risk as an option seller. If the strike price is less than the spot price, you get to keep the premium and you can sell another put option for free. This adds further income to your account balance.
In both cases, the market determines the premium. As you can tell from the AvaOptions UK trading platform at the time the trade is concluded, all gains/losses are based on the strike price of the underlying instrument. They will further determine the rate of the financial instrument at expiry time.
Why Trade Options?
At the end of the day, it is considered a safe investment in fact, for an option buyer, they are far less risky than trading the underlying. For a seller, the downside risks, too, are less than that of being wrong on a spot trade, as the option seller gets to set the strike price according to his risk appetite, and he earns a premium for having taken the risk. Options do require an initial investment of time, to get to know the product. Read more about risk management.
What Are the Benefits of Trading Options?
Options are regarded as safe investments. In fact, options buyers regard them as less risky than trading the underlying asset. For sellers, the downside risks are less than being on the wrong side of a spot trade. The option seller sets the strike price based on his/her appetite for risk. The seller will also generate a premium for taking that risk. Traders should understand the underlying financial instrument when trading options. For more information about risk management, click the link.
Take a Bullish/Bearish Perspective on Markets:
With options trading, you can go long or short on financial instruments at your leisure. If you are bearish on the GBP/USD pair, you can buy a put option based on your target expiration date, and wait for the trade to finish in the money. Regardless of the direction of price movement of the GBP/USD pair tomorrow, you are safe up until the expiration date. If you end up being correct, and the spot price is lower than the strike price by the premium value, you will generate profits.
Wide Variety of Trading Options
Experienced traders have many ways to use options. As a novice, you may likely be a conservative trader and prefer long strategies such as buying option spreads. These offer limited risk entry for newbies to the financial markets. AvaOptions provides you with a wealth of options based on your specific risk appetite and trading preferences. This naturally results in greater profit potential possibilities for you.
Execute Multiple Strategies
All financial instruments are associated with risks for profits and losses. The difference between trading options and trading spot is that with the latter you simply speculate on the direction of market movement. In other words, will the markets rise or fall. When you trade options, you can implement a trading strategy based on a myriad of factors. You can take the current price versus the strike price, your appetite for risk, market trends and movements, and other factors into consideration. You have greater control over your financial portfolio, and more room for maneuverability.
AvaTrade UK Learning Centre
When trading vanilla options at AvaTrade UK, you have access to a full education section direct from your trading platform. This is a premium benefit available to all registered traders.
AvaTrade UK Vanilla Options Trading
As the UK’s leading options trading platform, AvaTrade prides itself on delivering world-class trading facilities to our clients. Our customer-centric approach ensures that a wide range of trading tools and resources is available to you at the click of a button. We will guide you and assist you throughout your trading sessions. Simply download MT4 (MetaTrader4) the most sophisticated and popular trading platform on the market. You can start trading options at the click of a button. Choose the display that best matches your preferences, with a range of tools designed to help you profit from the financial markets.
Trade for real at AvaTrade – your trusted UK online broker!