Spread Betting On Options Explained
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Options provide the right, but not the obligation, to buy (in the case of calls) or sell (in the case of puts) a given security at a predetermined fixed price at some predetermined fixed time period in the future.
They are financial derivatives which allow investors to take advantage of the price movements in the underlying market without having to own the actual securities themselves.
Why is spreadbetting in this way appealing?
The key advantage of using these instruments is the significant reduction in initial price outlay and the transparency of potential losses.
Options are sold in contracts which typically carry a small fraction of the cost of the underlying market. For example, buying 1000 shares of company ABC might cost you £2 per share for a total of £2000. Buying a contract that gives you exposure to the movement of an equivalent amount of shares would typically cost you a premium which could be a tiny fraction of the total face value.
From this example, it is immediately apparent that one of the biggest advantages is the leverage that they provide, allowing you to gain exposure to larger amounts of the actual shares for less initial cash outlay than would be otherwise possible if you were trading the actual shares by conventional means through a stock broker.
Using 'calls' or 'puts', you can place up or down spread bets on the quoted price whilst knowing your maximum downside risk without limiting your upside profit potential. This is because the maximum that you can lose is the premium that you paid at the outset.
So, say for example that the FTSE100 is trading at 6300 and you think the market is going to rise further. You decide to buy FTSE100 6250 calls and so you call your spread betting broker who quotes 70-72 and you buy at £10 per point. [By the way, In this example, the 6250 level is referred to as the ‘strike price’ and the option is said to have an intrinsic value of 50. This is simply the current price of the FTSE 100 minus the strike price.]
If you are right and the market gains, then you win the difference between the new selling price and your purchase price
multiplied by your stake. In essence, your upside is unlimited. On the other hand if the Footsie dropped and you closed out your position, you lose the difference between the new selling price and your purchase price multiplied by your stake. Now, if say the Footsie fell so much that your 6250 calls went to £0, then your maximum loss is simply [72 x 10 = £720]. This is your maximum loss – no matter how far the market falls.
Key points about spread bets on calls and puts
In summary, spread betting on options is a highly leveraged activity and prices are very volatile. Yes, you could easily and quickly make a killing but then again, you could lose your stake just as quickly. But at least you know exactly how much you stand to lose the moment you place your bet.
The value of the position comes from two main components. The first is the intrinsic value, or how valuable the contract is already. The second is the ‘time value’. This is essentially the price you pay for the likelihood that the value of the option would increase with market movements over the period to the expiry of the contract. So, at expiry, time value falls to zero and the value of the option is simply its intrinsic value.
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