How to trade short-term volatility with daily options

For the majority of traders, volatility in the underlying market presents opportunity. Movement is needed for positions to make money after all, with appropriate risk management procedures required to limit any downside risk in case the markets move the other way.

However, there can be such a thing as too much volatility, when risk-off attitudes take over, liquidity dries up, and a thin order book adds to erratic movements and unpredictability. For some, highly volatile events result in inertia.

Even taking a position and adding a guaranteed stop to limit downside risk may not be the ideal course of action. If the market is whipsawing back and forth as uncertainty looms, there could be an instance where your guaranteed stop is triggered only for the market to move back in your favour.

The benefits of daily options

Buying options may be a useful way to trade over period of high volatility. Options allow you to trade on volatility itself, and whilst they are slightly more complicated then a regular spot or futures trade, they do add a new dimension for traders to access the market. In this article we’ll be focusing on buying daily options, however much of the below applies to other expiries as well.

Daily options are not available in the underlying market; however, we offer them on many of the most-traded instruments including FX, indices and commodities. As with all options things like underlying volatility, time until expiry, the strike, and the asset itself all impact the option premium.

The key benefits of buying daily options with IG Bank are:

• Variable intraday leverage gives you greater control over your leverage and risk
• Buying options is limited-risk. You’ll never lose more than the margin to open the trade
• No spread charged on the closing leg if held until expiry. However, you can always close the trade prior to this if the market is open
• We offer tight spreads, as low as the corresponding spread on the spot market. For example, if EUR/USD is a 0.6-point spread on the spot price, the daily option (high delta) spread would be 0.6 points as well
• Worthless positions could become profitable again. Unlike a spot trade with a guaranteed stop which would close if the stop level is hit, bought options can be held until expiry with a chance of the market rebounding and the position becoming valuable again

Put simply, you know your leverage and maximum risk going into every trade, you know you’re trading on tight spreads which you don’t pay the closing leg of if you hold until expiry, and you know there’s a chance for worthless trades to become profitable again if the market bounces back in your favour.

Which daily option strike do I trade?

The below assume an understanding of what daily options are, and more importantly of how you trade them with IG Bank. We will assume an understanding of payoff diagrams, how they settle, and profit and loss calculation. If you’re reminding yourself of the IG Bank options offering it may be worth having a look at our quick overview of how to use the options chain.

As we know, there are two types of options, calls and puts.

• If you think the market will go up, you buy a call
• If you think the market will do down, you buy a put

On the IG platform we show all the possible options to buy in an options chain. You can see the calls down the left, and the puts down the right. There are three ‘groups’ of options – ‘in the money’, ‘at the money’, and ‘out of the money’.

• In the money (red): an option which has value when immediately exercised
• At the money (yellow): an option which has a strike identical to the underlying market
• Out of the money (blue): an option which has no intrinsic value, only extrinsic value

In the above options chain, the rate of change of the options price, known as the delta, will always be between zero and one. On the call chain, delta 1 is at the top, whilst on the put side delta 1 is at the bottom. This means the options premium will move by one point with a one-point move in the underlying market.

In-the-money options, and how to trade them

Let’s imagine you think the market will rally – you would buy a call (assuming you wanted to buy the option and have a limited-risk trade).

In this example we’ll look at a FTSE option which is ‘in the money’ and has a delta of 1. We’ve gone with the 6920 strike (1 below) which has a premium of 252.4. You’ll notice the spread of this option is only 1 point, the same as the corresponding spot trade. As you are buying this option, 252.4 multiplied by your bet size would be the maximum risk. For example, a £1 per point trade would carry a max risk of £252.40.

As this is a delta 1 option, for each one-point move in the underlying the option premium would move by one point. If the market rallied 20 points the premium should increase 20 points, and if the market then moved down 25 points, the premium should also move 25 points.

The break-even point of this trade is the strike of 6920 plus the premium of 252.4, which is 7172.4. You can therefore see this is only 0.6 points away from breaking even against the 7171.8 underlying, shown just above the strikes.

At-the-money strikes

Options strikes which are ‘at the money’ are traded very regularly by those who are looking to buy volatility, without taking a directional trade in the market. You can use these strikes to buy an option strategy known as a straddle.

Buying a straddle means you buy a call and a put at the same strike. If you add the two premiums together you get your maximum risk. As long as the market moves more than that, the trade would make money.

As with all daily options, if you hold the position until expiry you don’t pay the spread on the closing leg.

Out-of-the-money strikes

Out-of-the-money strikes are those which require a move in the underlying market for the trade to have intrinsic value. They are highlighted below in blue, and as you’ll notice, they have significantly lower premiums than options strikes which are ‘in the money’.

You can trade out-of-the-money options when you want to:

• Hedge your existing open positions with an option
• Take a speculative view with a smaller premium

Let’s take the below put, which has a strike of 7140.

The premium on the 7140 put to buy is 21.6 points. This means buying £1 a point would have a maximum risk of £21.60, which is the maximum you could lose if the position ended up worthless.

The reason this is such a small number is because there is no intrinsic value to it. The market would have to move to the break-even price, which we’ll calculate next, to become profitable.

The break-even point, as this is a put, would be the strike minus the premium. In this example that would be 7140 – 21.6 = 7118.4. As you can see, the current market price is 7171.5. So the FTSE would need to see a 53.1-point move before expiry, about 0.74%, for this option strike to have intrinsic value. Obviously, the premium could still increase enough for the trade to become profitable before then, however that premium value would be hard to define given the number of factors that can have an effect on an option premium.

A summary of options strikes

Options give you a different way to trade the markets. Different strikes are useful for different things, but it’s worth understanding all of them so you can trade the markets, and possibly trade volatility, the way you see fit.