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When you buy a call option, it gives you:
Explanation
Buying a call gives you the right to buy an asset at a set price on or before a set date, while buying a put gives you the right to sell an asset at a set price on or before a set date. Remember, in both cases, you have no obligation to buy or sell if you won’t profit by doing so.
What is a strike price?
Explanation
The option holder can buy or sell the underlying asset at the strike price – sometimes known as the exercise price. For call options, the higher the strike price, the cheaper the option. For put options, the higher the strike price, the more expensive the option.
In a rising market you can make money by:
Explanation
Buying an asset below the market with a call option means being able to acquire it for less than its market value. A put option would work in a falling market, because it gives you the right to sell the asset for more than its market value.
Which key factors affect option prices?
Explanation
The underlying price provides a baseline, while the distance to the strike price, the market’s volatility and the time left to expiry all determine the probability that the strike will be breached. This equates to the level of risk for the option writer, and so affects the price they charge for the option. Your margin is based on the option price, but doesn’t affect it.
If the volatility of a security is higher, the option price will be:
Explanation
If the volatility of a security is high, there is a greater risk for an options writer. They will demand higher premiums to compensate for the extra risk of loss they may face. Conversely, low volatility means lower premiums.
When buying an option – either call or put – your maximum risk is:
Explanation
When you buy a put or call option, you have no obligation to follow through on the trade. If your assumptions were incorrect, your losses are limited to whatever you paid for the contract and trading fees. So your maximum risk is equal to the premium paid, which is simply calculated by trade size multiplied by price.
When selling a call option, your maximum risk is:
Explanation
When you sell a put or call, you are obliged to buy or sell at a specified price within the contract’s timeframe, even if the price is unfavourable. When you sell a put, if the price of the underlying asset should fall to zero, your losses would be limited to the whole of the strike price of your option. But when you sell a call, if the price of the asset rallies, there’s no cap on how high it can rise – so theoretically, losses are unlimited. (However, with us there is a negative balance protection on all accounts so losses would be limited to your deposit). Sometimes, but not always, you can set a stop limit to put a cap to your losses.
Buying a call option with a strike price of 6500 and a premium of 100 will result in a profit if:
Explanation
In this example, you have the right to buy an asset at a strike price of 6500. Anything below that results in a loss – you lose the premium you paid. But if it reaches 6500, you are no better off. There’s no point paying for the right to buy at the market price. If it reaches 6550, you can exercise the option and make some of the premium back – but it’s not until the asset reaches 6600 and above that you cover your premium – and start getting into real profit.
Selling a put option with a strike price of 6500 and a premium of 35 will result in a profit if:
Explanation
When you sell an option, you receive the premium. You need the option not to be exercised, to avoid the obligation it would give you. In this example, if the underlying expires at 6513, there will be no danger of the option being exercised, and you’ll keep the full premium.
Suppose you buy a strangle on an index currently trading at 6500, buying a 6700 call priced at 25 and a 6300 put priced at 30, at £10 per point (one contract). You’ll make a total profit on the strategy of...
Explanation
In this example, you would make a total profit of £450 if the index reached 6800 on expiry. At this point, the 6700 call is worth 100. However, you need to cover the cost of the 6300 put which expires worthless. So the overall profit of £450 is equal to the profit made on the 6700 call (100 - 25 x £10) less the loss on the 6300 put (30 - 0 x10), and the total premium paid of £550.
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