Spread Betting Markets: Options

The study of options trading is a course in itself. Unfortunately, options spread betting is often perceived as somewhat more complicated than other markets, however options help to limit risk and so can be a useful mechanism when spread betting the financial markets.

So I’ve expanded what I trade in from Lloyds Banking Group, to other banks, to FTSE index options and Currency options. What I like about options is that they are limited risk. That is, you don’t have to panic about losing endless amounts of money as you know up front the most you can lose. In this case there had been a lot of hype about the European Banking Stress Tests. Results coming out yesterday at 5pm.

My logic was that the announcement would cause a big jump or fall in the Euro. So the underlying euro/usd price was 12850ish and I put a call option at 13000 and a put option at 127000, cost 3p and 3.1p. I put 100 per point hoping for a big jump/loss as this would have made serious money. Say the price jumped (or fell) 2.5 cents at the announcement, I would make 10k.

But what is an option, you might say? When you buy an option, you buy the right but not the obligation to either buy or to sell financial securities at a certain price at a future date. If when the date comes around, it makes money to “exercise” or take up the option, then you make a profit; if not, then the option expires worthless, and you lose the cost of the option, called the premium. It is also possible to be the option provider, and receive a payment from the person buying the option. In this case, you obviously have no choice on whether the option is exercised, and may need to meet that obligation.

When you become involved in financial betting you may wish to consider betting on options.

Options are a kind of derivative. That is, a financial instrument whose value is derived from the value of another financial instrument. In the financial markets options are used to protect buyers against future price fluctuations and for hedging. So far as the financial trader is concerned they are simply another financial market whose value can be bet upon. However, it is important to note that unlike when you actually buy and sell options none of the options ‘bought’ through a financial bookmaker can be exercised.

If you are interested in betting on options first decide what type of options you wish to bet on. Your financial bookmaker will tell you what options are available. You can study the options market in question before placing your first bet. You can normally bet on stock index, commodity and individual share options, plus others depending on the bookmaker in question.

Most spread betting companies offer bets on two types of option, calls and puts. A call is the right to buy a particular market. A put is the right to sell a particular market. In each case you will be quoted the market, the price, and the date of expiry of the option.  For example, a March FTSE 100 Index Future 6500 is the right to buy the March FTSE 100 Index Future on or before a fixed date in March. With puts or calls your risk is limited to your stake i.e. should prices move in the wrong direction to the direction you anticipated you can just choose not to go ahead with the purchase or sale of the underlying – and the most you would ever lose is the price you paid for the contract.

IG Index will also allow you to sell ‘options’ – calls and puts in a similar way to the traded options market. If the market is below or above your strike prices, then on expiry, you simply receive the premium. Just remember that if you choose to sell an option, i.e. give someone else the right but not obligation to buy or sell at a certain price, your risk is potentially unlimited.

Key Principle : The value of options fluctuates according to the value of the underlying market, ie. the financial market from which it is derived. However, option prices also fluctuate according to the volatility of the underlying market and the time remaining until the option may be exercised.

Options are regarded as having two values : intrinsic value and time value. An option has intrinsic value if there is some gain to be obtained by exercising it. Therefore an option has intrinsic value if it confers the right to buy the FTSE 100 Index at less than the current price of the FTSE 100 Index. Options also have time value. This reflects the fact that even if the option is currently worth more than the underlying market, ie. the option is effectively worthless because buying it would cost more than buying on the underlying market, it may have an intrinsic value in future if things change.

There are two key advantages of betting on options. Firstly, they are highly leveraged bets. If your prediction of the market proves correct your win will not only be based on the change in the value of the underlying market but also the change in the value of the option. They also provide a degree of limited risk. If you bet that the price of an option will rise and it falls you can only lose a fixed rather than an unlimited amount, since the value of an option can never fall below zero. Indeed, an option will almost always have some time value even in the unlikely event that its value in the underlying market does fall to zero. The one main disadvantage with options is that, in some circumstances, the win from a successful bet can be less than betting directly on the market in question. In particular when markets get very volatile, options prices tend to go up.

Options Spread Betting Example

How to go long on a call option: It is March and the FTSE 100 is trading at 4920. City Index is quoting the FTSE June Call 4900 bet price is at 132 / 136.

You believe the FTSE 100 is due to rally over the coming weeks and therefore decide to open a long spread trade of £10 per point at 136.

Over the next few weeks the FTSE 100 rises and is now hovering around the 5100 market. The FTSE 100 June Call 4900 bet price is now at 275 / 279. You decide to take your profits by selling £10 per point at 275 (the sell price).

Outcome: You bought at 136 and sold at 275 – this amounts to a 139-point movement in your favour which, at your stake size of £10 per point, amounts to a tax-free gain of £1,390 (275 – 136 x £10).

Alternative scenario: If however, the FTSE 100 had fallen, you would end up with a £10 loss for every point the option price moved lower up to a maximum of the price you paid x your stake; £1,360 (0 – 136 x £10).

Remember if you buy a Call option or sell a Put option, the maximum you can lose is the price you paid x your stake. However if you sell a Call option or buy a Put option, your losses are potentially unlimited, so make sure you have a risk management strategy in place.

Notes : The spread is not very good with IG Index (I suspect it’s the same for all spread betting firms). For example, a call option which on Liffe would be priced at say 22-23.5 (that’s about a 6% spread) would be something like 20-25 on IG Index. Of course, just looking at the raw spread percentage on leveraged derivatives isn’t particularly meaningful as this may map to a much smaller spread on the underlying, which might not be much but still… Having said that with spread betting options there are no other charges – all we pay for is included in the spread. However, even with the US options, you’ll still have to pay CGT, whereas with spread betting, you won’t need to pay ANY CGT at all, and so the pain of the larger spreads is somewhat compensated for by the non-payment of CGT.

Spread betting on options is a good way to play volatility on indices. Let’s say it is USA non-farm payrolls day and you are unsure where the market will be heading.  You could create an index straddle by buying both a put and a call on the same index, each contract with the same strike price and expiry.  The two positions cancel each other out and as such it doesn’t matter to you which way the price moves – as long as it moves.  Here you are hoping for a big movement since options prices tend to rise when volatility increases.

Which spread betting companies allow you to sell options? IG Index do options on the major indexes – FTSE, Wall St, France, Germany, SPX500, and gold, oil, and many currency pairs. I’ve only dealt with FTSE options so far. City Index offer option bets on major indices, a few currency pairs and near-month gold and oil. The last time I checked ETX Capital also quoted options which allows them to take longer-term positions, with limited risk. Not much else though so a bit limited.

Clever Strategy : Although to succeed in options calls for some study of not just options but of the underlying market a useful strategy to follow is this : Buying options usually proves profitable when the market is fast moving. Selling options usually proves profitable when the market is static.

Pricing of options is a complex topic, which includes variables such as the assigned price, the time until the option expires, etc. Unless you are interested in learning about options, it is probably best to avoid spread betting on them.