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What is an Options Contract? with Lee Sandford MSTA, CFTe, Tradingcollege.co.uk

Vanilla options may complimentyour trading portfolios; liberating you from simple up and down trends and opening up an expansive hub of trading strategies to seek more opportunities and diversify risk. Here are three benefits of trading options:

 

  1. Through buying options it may be possible to trade a large directional move with a small and limited risk
  2. Options allow you to trade changes in volatility as well as direction; you are no longer solely tied to the ups and downs of the market
  3. Through trading multiple options at the same time you may create ‘strategies’ that open up hundreds of new trading tactics.

 

The following article gives the theory behind buying options and how they may be traded using an online platform. In future articles I will explain how you maycreate strategies but for now let’s get to know the basics!

 

An example:

You walk into a Jewellers and you see a gold necklace. The cost of the necklace is $5000. You want to buy this for your wife as a wedding anniversary gift. But you are unsure because your anniversary is in one month’s time and the value of gold may go down, however there is also a chance that the necklace price will go up if demand for gold rises!

 

Now imagine the jeweller makes you the following offer; if you pay $50 today you can make a contract where he guarantees to sell you the necklace for $5000 anytime in the next month, even if the necklace price goes up and, if the necklace price goes down you can buy it at the cheaper price. Also, you are allowed to sell this contract to anyone else who can ‘use’ it. That means if you decide you don’t want to buy the necklace you can sell this contract to someone that does.

 

This isa fantastic deal, for a hundredth of the value of the necklace you can guarantee to buy it at the current price or lower, and if you change your mind you can sell the contract to someone else. You sign the contract, pay the $50 premium and walk out of the shop smiling knowing you have all bases covered. Over the next month, you will monitor the change in price of the necklace and decide how to make the most of your contract.

 

The contract is known as an ‘option’. You have the choice or the ‘option’ to buy the necklace at $5000 from the jewellers anytime in the next month. More specifically, this is a CALL option; your option to buy at a certain price for a certain period of time.

 

The jeweller is the seller (or ‘writer’) of the option contract. They earn $50 but bear the risk for this exchange.

 

Financial Jargon

In the financial world there are many unfamiliar words which can be daunting but don’t let that put you off, once you have a better understanding these words become easy! Here are a few options related words:

 

  • If you chose to ‘use’ your option, to buy the necklace, this is called ‘exercising’ the option.
  • The last day of the option contract is called the ‘expiry’ date
  • The price you have reserved for the necklace, that is $5000, is called the ‘strike’ price
  • The $50 paid to the jeweller is the ‘option price’ or ‘premium’
  • There are two ‘types’ of option contracts; a CALL and a PUT. Through buying a Call option you may reserve a buy rate in the market over a certain period of time and through buying a Put you can reserve a sell rate in the market.

Remember, we said you may sell the option to anyone else. Why would you consider doing this? Over the next month, if the necklace price goesup your option contract becomesmore valuable. This is because the contract you own will be offering a better price for the necklace than the market price. For example, the necklace price may be $6000now but via your option contract you can buy it for $5000. Therefore, the option contract is worth more and you may sell it for more than the $50 you paid.

 

This is exactly how options are traded via anonline trading platform. You may buy options in order to speculate on changes in the price of an asset and you do not actually want the physical asset to be delivered to you! In our example the asset was the necklace but in the financial markets the asset could be currencies, precious metals or oil.

 

Online Trading

The below image is a buy Call option contract example that demonstrates trading an uptrend in Gold (XAU/USD). The contract allows you to reserve 10 ounces of gold at $1185.00over the next 7-days. The cost to buy this option contract is 95.14 USD.

 

Five steps to setting-up an option:

  1. Select the pair you want to trade, for this example we have chosen ‘XAU/USD’
  2. Select the option type, we have chosen ‘Call’
  3. Enter the strike rate. We have entered 1185 since we expect the market to rise above this level
  4. Depending on the duration you expect the move to happen, select an expiry date – we have chosen’ 7 days’
  5. Enter an amountyou wish to buy, we have reserved to buy’10 ounces’.

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If gold price subsequently risesthe value of this option contract (the premium value) will rise and you may close at a profit. On the other-hand, if gold price falls you will incur a loss, but this loss is limited to the amount you paid for the option, that’s 94.14 USD. Even if gold falls to $0, your risk is never greater than 94.14 USD.

This is what makes buying options unique; the maximum risk of any trade is the amount you pay for the option (the premium). It means investors may take directional positions without having to make use of a stop loss order.

Once you have opened an option contract you can view its real-time value from the ‘open positions’ screenand may choose to close at any time before expiry. The below image shows fiveopenoption positions. Here it is clear to see the ‘premium at open’ and the ‘premium now’, the difference between these values is the profit or loss. For example, looking at the AUD/USD option on the top line; 1,127.37 USD was paid to buy this option (premium at open) and it is now worth 1,623.68 USD hence the real-time profit is 496.31 USD.

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Trading a Downtrend – Buying Put Options

So far the examples have explained how you may benefit from an asset’s price going up, however it’s also possible to trade a falling market. Put options are used to reserve a sell price in the market over a certain period of time. Under the same reasoning as the example above, you may buy a Put option to trade a falling price. If the price falls, the Put option allows you to sell at a higher price than the market price hence youroption contract is worth more and you may close at a profit.

In my live trading room we enjoy shorting the markets and buying Puts. We know fear is a bigger emotion than greed so the markets tend to fall further faster. However, we need to get our entry and timing right if we are going to make a profit from buying an option. I like to use my Elliot Wave counts and my propriety indicators. By combining these, I have a high probability of being on the right side of the markets. I can even use the Weekly expiry options after a trade signal that has happened on the Friday prior to weekly expiry date. We all enjoy setting up these weekly options and seeing these options expire with a profit on a weekly basis.