There are three main reasons for trading options: to limit your risk by hedging, to buy yourself time to decide if a trade is right for you, or to speculate on the price movements of various markets. While they have other uses – such as in complicated spread strategies – the majority of traders will use options for one or more of these.
Hedging with options
Options trading was first devised as a hedging tool. Say you owned stock in a company, but were worried that its price might fall in the near future. You could buy an option to sell your stock at a price that’s close to its current level – then if your stock’s price falls, you can exercise your option and limit your losses. If your stock’s price increases, then you’ve only lost the cost of buying the option in the first place.
Buying time to decide
Another key use for options is to extend the time you have to decide about whether a trade is worthwhile. Here, instead of buying a market that you aren’t entirely sure about immediately, you buy the option to trade it before a set date in the future. If, further down the line, you decide that you want to buy the market then you can exercise your option. If not, then once again you’ve only lost the premium.
Speculating with options
The flexibility of options has also made them a popular tool for speculation. That’s because the prices that options trade at will vary depending on a number factors, including how much time you have left to exercise your right to trade, and the value of the underlying market. An option to buy gold for $1300, for instance, will typically trade at higher price when gold is at $1299 than when it’s at $1200.
Speculators might trade options with no intention of ever exercising them. Instead, they’ll buy an option then sell it on when its premium increases.
One of the biggest benefits of options is their flexibility. You can trade a huge number of markets, like futures options can be used to buy and sell assets that would otherwise cause logistical issues, such as oil or gold.
Here are some of the asset classes that you can trade with options:
- Currency: Including majors like EUR/USD, GBP/USD, USD/CHF and EUR/GBP
- Shares: Including FTSE® 100 shares and a selection of leading US shares
- Stock indices: Including the FTSE 100 and Wall Street
- Commodities: Including metals and energies
You can also use options over both the short and long term. A daily option, for example, will expire at the end of the day – whereas weekly or quarterly options will have expiries further ahead.