The principles behind Options are explained in simple terms below, along with the basics of trading them.
What is an Option?
An option is a type of derivative which lets you trade on the future position of an underlying market. If you purchase an option, you secure the right but, importantly, not the obligation to buy or sell an asset in the future at a set price.
CFD trading options are split into two: Puts and Calls
- A put option is the right to sell an underlying instrument at a certain price
- A call option is the right to buy an underlying instrument at a certain price
Read more about the Types of Options available.
Trading gold with options
Taking gold as an example, like any commodity traders would typically aim to sell it at the highest possible rate and buy it at the cheapest.
You believe that gold is set to rise from its current underlying price of, for example, US$1400 per ounce, and you are thus keen to buy it at or around that price. So you decide to purchase an option to trade gold at US $1410 (a Call Option), which gives you the right - but not the obligation - to buy at US $1410, on or before a set expiry time.
This level is your 'strike price' - the premium you've paid for the option.
Should the price of gold increase to US $1500 per ounce, for example, your option to buy gold at US $1410 would be valuable, as you could sell the option for profit or buy gold below market value.
If, however, the price of gold were to fall to US $1350 at the time when your option expires, the option would be worthless. A right to buy gold at US $1410 would be of no value, given this is higher than market value. In this event you would lose the premium you had paid. A longer-term option obviously gives you a longer period before expiry, and thus more time for the underlying price to fall further, or rise back in your favour.
Options can be an effective trading tool in times of market volatility, allowing you to essentially trade on future volatility itself.
An important point to note is that you are not physically buying or selling an option, and that it can never be exercised (i.e. you cannot buy the gold used in the example above). Rather, you are simply trading on the value of the option.
Pricing
Several factors impact the price of an option:
- the level of the underlying market relative to the strike price
- the length of time before expiry of the option
- the volatility of the market
Learn more about options
To find out more, take a look at our options examples, or view our online seminar for a fuller introduction to these products and simple dealing strategies. Some terms related to options are also discussed in our trading glossary.