Borne on a wave of volatility started by US-China trade tensions, Brexit and now a global pandemic, the practice of options trading has grown significantly over the past few years.
As prices and exchange rates are changing more frequently and more dramatically, traders are looking to seize the opportunity to capitalise on the high rewards on offer – but they are also conscious of the higher risks.
This has prompted many – including those in the retail market – to revisit the power of options trading, which offers a chance to profit from these opportunities while limiting the downside risk.
So, what does options trading entail? How does it achieve this favourable balance of risk and reward? And why, given that we have seen many periods of volatility in the past, is it only now that it is coming to the fore in wider circles?
What is options trading?
To offer a simple explanation, options trading is the buying and selling of financial contracts (known as options) that allow, but do not require, the owner to buy or sell an underlying asset for a certain price within a set period of time. Traders can either buy a “call” option, which gives them the right to buy an asset, or a “put” option, which gives them the right to sell an asset at the predetermined price.
For example, a trader expecting the euro to weaken versus the US dollar over the next month might want to purchase a put option on the EUR/USD exchange rate, enabling him to sell euros and buy US dollars at the current market price, with an expiration date in 30 days. If the dollar gains against the euro over that period, as predicted, the trader can exercise his option and lock in a profit from selling euros at the higher rate.
Benefits of options trading
Options offer a more powerful and flexible way for traders to express their market views compared to spot trading. Options, and combinations of options collectively called “strategies”, allow traders to match their portfolio risk to their precise market views.
Without options, the only tools available are buy, sell, and stop-loss. You are in the trade, or you are out. Options let traders shape their destiny, balancing risk and reward against market views, while offering precise hedging tools to anyone with defined risk.
Trading options is also markedly less risky for investors. When trading spot prices, investors have to commit their capital up front to cover any adverse move, whereas, when buying options, the only exposure you take on is the premium to buy the option in the first place.
This means options put traders in a much better position to control their exposures than spot trading does. Combine that with the fact that traders still have the potential to gain a significant amount of money with the higher percentage returns, and it’s clear to see how trading options can be an attractive approach.
And there’s more. As previously noted, options are contracts between two parties – the buyer and the seller. The seller of an option earns the premium paid by the buyer to accept risk, just like an insurance company receives a premium for protecting buyers against risk.
Selling options offers an entirely new dimension to trading, a new potential source of income and profit for those willing to take risk. With combinations of calls and puts, bought and sold, at chosen strike prices and expiration dates, traders can maximise their returns for their given view and risk appetite.
The evolution of options trading
Why is it then that we are only now seeing a significant uptake in options trading among retail traders, and how is options trading likely to further evolve?
Despite options trading having been on the scene for some time, it has only been within the last few years that it has been made easily available for the mass markets. Until around 10 years ago, options were traded almost exclusively by institutional investors, large companies and a handful of high-net-worth individuals, as opening the required account at a well-established bank requires significant capital.
Options trading has also retained a somewhat esoteric image over the years, which has perhaps discouraged entry to the market for many participants. In the past, trading options meant successfully navigating clunky and confusing desktop screens, densely populated with numbers and with little if anything in the way of visualisation to help traders spot patterns at a glance.
You had to be well versed in both the markets and the interface to be able to understand what was happening on the screen and to be able to determine what options to buy and when. This, combined with the range of different strategies that come with options trading, meant that, for a long time, it was a discipline best left to the experts – despite its many advantages.
Within just a few years, however, options trading has been dramatically transformed, with fintech companies stepping in to take advantage of rapid technological progress.
These companies have opened up the world of options trading to a new and wider market, meaning that anyone with £1,000 to invest can start using options as part of their strategies.
At the same time, new and improved desktop platforms have emerged, alongside new mobile platforms, both of which make accounts more convenient to open, access and manage.
Powerful and innovative online trading platforms, such as AvaOptions, enable traders to have complete control over their portfolios using interactive interfaces where they can execute multiple strategies. On the same smartphone we use to answer calls and texts, traders can also buy options to hedge risk or take a view, sell options to generate income, access risk management tools and portfolio simulations, and trade calls and puts with stop and limit orders, all at the touch of their fingertips.
Power to the people
All of this has done wonders to erase the days where access to options trading was the preserve of an elite few. But more than this, platforms have also evolved to demystify options trading, peeling back its arcane façade and lightening the cognitive load incumbent on traders with dedicated features to provide the full range of information needed to underpin a trade, make all the necessary calculations to lay out the stakes clearly, and provide vivid and easily understandable visualisations of the potential paths.
For example, through AvaTrade’s mobile platform, AvaOptions, a trader looking to buy a call option can see the basic elements of the trade – from the proposed quantity of the asset to be bought under the options contract, the strike price (the price at which the asset can be bought under the contract) and the expiration date.
This comes alongside a chart showing the historical behaviour of the underlying asset up to the day’s spot price (with the option to zoom in to see a detailed picture of intra-day movements or to pan out to see a longer-term week-, month- or year-long picture).
However, it is perhaps the visualisation of these factors that has begun to make options trading so accessible to a wide audience of traders.
In AvaOptions, the strike price for a given trade is shown as a line cutting across the pricing chart for the underlying asset and can be dragged up and down to reflect the trader’s preferences.
As it does so, the line on the price chart moves with it, making it immediately clear where the strike price stands in relation to current and historical pricing.
As the strike price changes, of course, so do the chances and size of the profit (or loss) you stand to make. Calculating these odds is a complicated process, but modern platforms generate these results instantly and automatically – and reflect it on a colour-coded curve, making it immediately clear how much you stand to gain or to lose when taking on a given position.
Strategy made simple
All of this makes executing and understanding the stakes of an options trade infinitely simpler than it once was. Traders of all kinds are now in a position to quickly execute vanilla options trades, configuring and understanding, for instance, a put option that allows them to sell an asset they think may decline in value over the next month for today’s spot price.
But options can be combined with one another and with spot trades to create a whole world of new and interesting strategies to maximise profits. And new platforms mean that these, too, are now well within reach for retail traders.
For example, a simple strategy, popular during periods of high volatility, is a call spread, which can be used to capitalise on price increases in a given asset with limited downside risk, and limited upfront cost.
To execute this strategy, a trader buys a call option at one strike price, and simultaneously, sells a call option at a higher strike price.
At expiration of the options, if the asset price falls within that spread, the trader has exposure similar to owning the asset outright. As the market moves higher, he profits, and as it falls, he suffers losses.
The downside risks are well hedged with this strategy. First of all, the cost is lower than that of a straightforward call option, since the trader also receives a premium for the sold call option at the higher strike price.
If the price falls below the lower strike price, the trader loses their premium on the call option they bought, but can make part of that back from the premium on the option they sold.
On the other hand, if the asset price exceeds the strike price of the higher call option, the trader loses out on the sold call option, but wins much more on the bought call option. This caps the profit that can be realised on this trade at the difference between the two strike prices, minus the original premium paid.
By changing the strike of the two call options with your fingertip, and choosing the expiration date that matches your view, you can create the exact risk profile that you like. The platform gives immediate feedback by continuously updating the option prices and red and green profit/loss chart.
It’s a strategy with a clear and sensible trade-off: it lets the trader establishing the bullish exposure he wants, and also allows him to sleep at night.
This is just one of the many strategies that can now be readily explored and executed within today’s options trading platforms. Above, for instance, is a screenshot from the AvaOptions platform, outlining the different strategies that could be put into effect.
Each comes with its own explanation and a dedicated function for executing them. This means traders have the knowledge at the fingertips and can execute instantly, rather than having to set up each constituent trade in a strategy one after the other.
This level of user-friendliness is fast becoming the norm in options trading. The gates are being flung open on what was once a relatively obscure and little understood world. And the timing couldn’t be better – volatility is fuelling significant price movements, creating opportunity and risk in equal measure. An informed community of retail investors, with the full power of options trading at their fingertips, will find themselves better equipped than ever to profit from the opportunity and limit the risks.
This article was originally published on e-forex.net