In this article you will learn how to trade (financial) options, which are among the most well-known products used by traders in the markets.
We will focus on call and put options, and in particular on the following.
1) Which options are worth investing in now that binary options have been banned?
2) What call and put options are and how they work.
3) How to make money with options trading.
4) What are the advantages of trading options?
5) Which options should be traded to be profitable in the stock market?
6) What is the best broker to invest in options and what is our most important advice?
Binary Options: Prohibited in Europe
In the world of finance, there are many types of options with different characteristics, for example:
- European options
- American options
- Asian options
- Exotic options
- Binary options
Probably the most famous of these are binary options, but they were banned for all non-professional traders under a new ESMA regulation in 2018.
This means that no broker regulated and licensed in Europe can allow investors to trade binary options.
Importance of call and put options
Since it is no longer possible to use binary options, we will focus on European options as these are the most traded in online trading today.
First, however, we need to understand the difference between call options and put options.
Call options are contracts that give the trader (called the “buyer”) the option to buy the asset to which these options relate (called the underlying asset or “underlying”) at a fixed price and on an expiry date specified in the contract.
In contrast, put options are contracts that offer the possibility of selling the asset on which these options are issued at a fixed price and on a specified expiry date.
Call and put options: How they work
Options are derivative products, i.e. financial instruments that literally “derive” their value from another asset.
The underlying asset of a derivative can be virtually anything that is not necessarily financial in nature. For a better understanding, here are some examples:
- Shares, and in this case we are talking about stock options.
- Bonds, which will be referred to as bond options hereafter
- Futures and market indices, as in the case of the famous MIBO: options, whose underlying is our stock market index, the FTSE MIB
- Currencies and the whole world of Forex
- Commodities, such as gold and oil
- Options themselves and other derivatives
Be careful! Buying an option does not mean buying the underlying asset at the same time. For example, if you buy a “written” option on Meta shares, you only own the option, but no Meta shares in your portfolio.
Like any instrument in the financial markets, options have a price called a “premium”: This is nothing more than the payment that the buyer must make to the issuer of the option in order to enter into the contract.
The expiry date of options is called “maturity”, while the price at which the buyer can buy or sell the underlying asset is the “strike price”.
Options are defined according to their “moneyness”, which takes into account the difference between the current market price of the underlying and the strike price of the options. In detail, we distinguish:
- Call in the money (ITM): current market price of the underlying (P) > strike price (K).
- Put in the money: P < K
- Call and put at the money (ATM): P = K
- Call out of the money (OTM): P < K
- Put out of the money: P > K
How to make money with options trading
The contract becomes valid from the moment the buyer purchases the derivative and remains in force until the expiry date.
When the contract expires, the buyer can:
- Exercise the option: the buyer buys or sells the underlying asset by paying (for call options) or receiving (for put options) the strike price.
- Failure to exercise the option: the contract is closed out
To determine whether it is worth exercising the option, one must introduce the simple concept of the return profile (“payoff”) of an option.
The payout amount is the amount the holder would earn if they exercised the contract. But how does it work?
Let’s start with call options and their definition. Call options are contracts that give the holder the right, but not the obligation, to buy the underlying asset at a fixed price, called the strike price, on the expiration date. It goes without saying that it is more advantageous to exercise a call if the value of the underlying asset at maturity is higher than the strike price!
The holder of the option pays the strike price and can sell the underlying asset on the market. The payout is therefore the difference between the value of the underlying at maturity and the strike price of the contract.
What if the value of the underlying at maturity is less than the strike price? In this case, it is possible not to exercise the option.
Since the difference between the two values would be negative and nobody likes to give money away, the option is simply not exercised and the payout is 0.
However, the original price paid to conclude the contract must not be forgotten! The payout is not the end result of the investment. If the option is not exercised, the buyer has a loss equal to the premium.
Example of a call option
Let’s take a simple example: suppose you bought a call option at a price of $5, the strike price specified in the contract is $40 and the value of the underlying asset at maturity is $100.
In this scenario, the payout is $100 – $40 = $60, from which the premium of $5 must be deducted. In total, we would have earned $55.
On the other hand, if the price of the underlying asset is $20 on the expiry date, we would suffer a loss of $5.
You will have guessed the advantage of options: If we were forced to exercise the contract, the total return would be $20 – $40 – $5 = – $25 (we would have to pay $25). However, options only give you the opportunity to exercise them when it is most convenient!
Advantages of trading with options
However, a question arises: If you think that the value of a share will rise in the future, why not buy the share outright and then sell it at a higher price to make a profit?
Why would you complicate matters by buying a call option?
The benefits of options are many, we can assure you. We will now focus on the two most important ones.
Options have a higher return (correspondingly also a higher loss)
If you make a profit, the return you would get from buying a call option is far higher than buying shares. And why?
Let’s assume that Meta is worth $225 today and that we believe the value of the company could still increase significantly.
An ITM call option with a strike price of $220, a maturity of one month and a premium of $8 is available on the market.
There are two possible strategies:
- Buy the Meta share at a price of $225.
- Buy the call with a strike price of $220 and a premium of $8.
Assume that Meta’s share price has risen to $245 in exactly one month when the option expires.
What is the return on the two strategies?
- Return on the stock = ($245-$225)/$225 = 8.9%.
- Option return = ($245-$220-$8)/$8 = 212.5%.
Yes, you read correctly. The percentage return of the “buy options” strategy is 212.5%, an incredible figure compared to the alternative of 8.9%.
The reason for this is quite simple. When buying options, you only have to pay the premium, whereas with shares you have to pay the full value of the share.
Options have a higher risk
Remember that once the option expires, the position in the portfolio no longer exists. Options are therefore an expiring investment, which is not the case with shares, which can be held for any length of time.
Options are riskier than shares because you cannot hold options forever.
What would happen if Meta’s share price fell drastically within a month, as described in the previous example? Such things happen in the stock market. The possibility of expectations being disappointed is part of the reality of the markets.
“How to play the stock market at its best”.
Suppose that Meta’s share price falls from $225 to $200 in exactly one month. Under the two strategies above:
A) Loss from shares = $225 – $200 = -$25
B) Loss from option = -$8
For the Meta share, the net loss is $25. However, since it is not worth exercising the option, the loss is only the premium of $8. This is why people say that options work like insurance: In the worst case, the option is not exercised and the contract is closed with a loss limited to the premium.
Conversely, it is worth buying a put option if you have pessimistic expectations about the value of the underlying at maturity (lower than the strike price). The process is a mirror image.
One thing to keep in mind when trading is that call options are generally more expensive than put options.
The reason again lies in the payout. The price of the underlying asset can rise dramatically while it cannot fall below zero. So if the potential payout of calls is (theoretically) infinite, that of puts is limited by the fact that there are no shares with a negative price.
Which options are best to trade?
To understand which options are best to trade, one must consider the volatility of the underlying asset.
Volatility is the frequency and magnitude of positive and negative fluctuations in the value of an asset. Knowing the volatility of the underlying asset forms the basis for deciding whether to buy/sell options:
- It is not worth buying an option if the value of the underlying asset remains the same over time. One therefore buys call/put options if one believes that the underlying asset can make large price jumps.
- Conversely, market participants sell options if they expect low volatility.
When analysing the behaviour of the underlying, one not only examines its trend, but also its volatility!
It is not surprising that one often reads the statement: “Those who trade options trade their volatility”.
How to trade options with Plus500
Plus500 is one of the most popular trading platforms in the world and one of the best for trading CFD options.
We also appreciate Plus500 for its interactive charts, which are ideal for technical analysis due to the many indicators that can be implemented.
Signing up is free and with the creation of a demo account, you have virtual €40,000 at your disposal, which you can use to run trading simulations to learn how to use the platform and test your strategies.
You can sign up for a demo account for free and in less than two minutes directly on Plus500’s official site, which you can access via the button below.
79% of retail investor accounts with this provider lose money trading CFDs. You should therefore weigh up whether you can afford to take the risk of losing your money.
Below we explain how to trade options with the platform, while we refer you to the Plus500 review for more information about the broker.
After logging into your account, select “Options” from the menu on the left to see all the contracts available on the market, or search directly for what interests you by using the search bar at the top.
In our example, we use the options on the Meta share by using the search function: We then have the meta-share, the different call/put options with their different strike prices and expirations, their buy/sell price and the historical chart.
For each option, one can click on the information icon to get all the details of the contract.
The most important features are listed: Buy/Sell Price, Strike Price, Quantity, Issue Date, Maturity, Trader Opinions, Percentage of Buyers and Sellers in the Market, etc.
Disclaimer: All prices revealed by the graphic above are illustrative prices.
Now all you have to do is buy or sell the option you want (e.g. sell the option at 3.05 or buy the option at 3.19 / the spread in this example is 14 cents) by clicking on the appropriate button.
When using online trading platforms, CFDs on options are traded, so there is no need to manually sell/buy the underlying asset of the option at maturity or exercise the option (this is all done automatically): The fulfilment of the trade is already settled in cash. When you close a trade with a profit or loss, the investment profit or loss will be directly credited to you or debited accordingly.
No overnight commissions are charged for such CFDs at Plus500. In addition, the strike price is only a reference factor as the profitability of a position (which you can close at any time: You do not have to wait until maturity to realise the gains or losses is based on the fluctuations in the value of the option underlying the CFD (the broker’s website displays the underlying and therefore the strike price and the reference expiry date) and not on the difference between the option’s underlying and the strike price at expiry:
- If you bought the CFD on a call option, your profit will increase if the call option rises in price. Your loss increases accordingly when the price falls.
- If you bought the CFD on a put option, your profit will increase if the price of the put goes up. Their loss increases accordingly when the price rises.
Remember that you should buy a call option if you believe that the value of the underlying asset will be above the strike price at maturity.
Instead, opt for a put option if you believe that the price of the underlying asset at maturity will be below the strike price specified in the contract.
TIP: CFDs on options are extremely volatile instruments by their very nature, as they are derivatives of derivatives that are already very unstable. For this reason, we advise inexperienced traders to trade CFDs on shares or actual shares (“Invest in Shares”) via the eToro platform. You only need $50 to get started!