“Options give you a range of choices in how you approach a trade,” says Kevin McPartland, head of research at Greenwich Associates. “For example, in a bullish situation, do you go long or do deep out-of-the-money call options? Or even be more speculative and buy the stock?” This same choice is open to investors when approaching any instrument – from foreign exchange to gold – but there are no ‘other instruments’ quite like options within traditional derivatives trading with UK options market.
So if an investor wants exposure to UK options market listed equities without buying shares directly, they can enter into a variety of tradable contracts that offer exposure with less capital exposure than the underlying shares themselves. We take a look at these trades and their associated risks and rewards.
Calls and puts- UK options market
When buying options, the two most common types are calls and puts. A call option gives the holder the right but not the obligation to purchase a security or instrument at a set price (the strike price) on or before a specific date (the expiry date)
For example, imagine Company ABC is trading at 100p per share. You believe that in six months, the price will be above 110p, so you buy a call option with a strike price of 110p, which will expire in six months. If the share price is above 110p at expiry, you will exercise your right to buy the shares at 100p – even though they are now trading at 120p. However, if Company ABC is still trading at 100p, the call option expires and becomes worthless.
The same principle applies to puts – except, in this case, you have the right to sell shares or an underlying market instrument such as a currency. For example, if you believe that ABC will fall below 90p by expiry, you might buy a put with a strike price of 90p, giving you the right to sell 100 shares in ABC for 90p each in six months.
It must conform to something known as ‘put-call parity when buying either option. Put-call parity ensures that options on one security are comparable to the cost of the same type of option on another security.
For example, if you were to buy a call for company ABC with a strike price of 100p, there should be some put contract available for ABC, which has an equivalent or lower strike price. It will ensure that the total value at expiry is 0. Put-call parity must hold at all times – even when one instrument is trading at implied volatility higher than another
“If it wasn’t true, you could make money by creating baskets of options and selling them off”, says McPartland; “People wouldn’t create risk in this way, so somewhere along the line, put-call parity is going to hold.”
Option pricing models
Options can be valued using several mathematical formulas, including the Black-Scholes model, which measures the value of an option based on stock price, time until expiry and volatility.
This formula calculates the theoretical value of such options based on specific inputs such as implied volatility and share price.
It also assumes that returns are logarithmic, meaning there are no sudden changes to returns – but this isn’t always the case in reality, so it’s essential to use market data where possible.
When establishing how much an option should cost to buy or sell, investors must cover all their costs. These include transaction fees, stamp duty or commissions. “Some online brokers will reduce or waive these costs if you trade options with them,” says McPartland.
There are a few risks that come with trading options:
- Time decay – as an option gets closer to expiry, its value decreases, as it becomes more and more likely that the option won’t be exercised.
- Volatility – if the underlying security experiences a lot of volatility, then the price of the option will also increase (and vice versa)
- Assignment risk is the risk that you will be assigned the shares or other instruments if you buy a call or put option.
Sign up for a free trial here and avoid all risks.