Spread Betting on Options – A Beginner’s Guide
Most spread betters use their trading accounts to trade shares, indices, currencies, and sometimes commodities like gold or oil. Beyond those markets there is a grey area that traders either avoid for lack of knowledge or just don’t know about it.
The stiff competition among spread betting firms resulted in major improvements not only in terms of tight spreads but also in terms of the range of products offered. Any serious spread betting provider offers not only a wide selection of shares, indices, and currencies but also some other less common markets. One of those you may have been missing is: options.
Options are a complex derivative when compared with a straight spread bet or CFD because of the effect of volatility and time to maturity in their price, but it does not mean you cannot master them and use as a tool for protecting risks, implement trading strategies, or maybe just speculate on prices.
What is an option?
You could spend years learning all the nuances of options trading, but the basics are actually pretty simple. First of all, an option is a contract between two parties: you and the spread betting provider in this particular case. Second, it is a contract giving the owner the right to buy or sell a security at a predefined price and until some date.
You can buy or sell call options and put options. The call gives you the right to buy an asset; the put gives you the right to sell an asset. As an example, let’s say you acquired a call option on FTSE 100 with a strike of 5,000 and maturity date three months from now. That option gives you the right to buy the FTSE at the price of 5,000 until its expiry date that occurs three months from now. If at maturity, the FTSE is quoted at 6,000, you will exercise your right to buy it at 5,000 to lock in a profit of £1,000. If the market is below 5,000 the option expires worthless since you certainly do not want to buy the FTSE at 5,000 when it is quoted below that level, do you? A put option works the same way but gives you the right to sell. If you had a FTSE put option with exercise price of 5,000, you would exercise your right if the index were below that level, otherwise the option would be worthless.
In spread betting you don’t really exercise an option. Instead, a financial adjustment is made. At the maturity date, in the case of the above call example, £1,000 would be credited into your account instead of you having to buy FTSE for £5,000. You can then buy for £6,000 and use your £1,000 credit, if you wish.
Options can of course also be traded before maturity. You can sell (or buy back) your options back to your spread betting firm the same way you would sell or buy any other trades on shares or currencies that you hold.
Which options markets are available for spread betting?
The short answer is: more than you think. There is a huge number of different markets because spread betting firms offer options for several underlying assets with many different strike prices and maturities. Just for FTSE as underlying there are hundreds of different options at IG Index, for example.
In terms of asset classes, most firms offer options on indices (FTSE, Dax, SPX, Dow, and sometimes in other), on the major currency pairs and crosses, and on commodities (usually oil and gold).
Regarding maturity date, you will find inside each asset classes several alternatives: daily, weekly, and monthly options.
Then you have to decide on the option direction or type: a call or a put. If you’re bullish a call is what you want. If you are bearish, then a put is what you’re looking for.
At this point there is one important detail worth mentioning: in spread betting you can be either way of a call and a put. You can short a call and a put. That is the beauty of options in spread betting. That feature allows you to apply many strategies that you can’t in traditional trading and gives you a huge flexibility.
The last choice to make is related to the strike price. After choosing on the direction, maturity, and underlying asset, you still have to choose the strike price. You can opt for expensive in-the-money options or the cheaper out-of-the-money ones. Or maybe you want equilibrium and choose at-the-money options.
Transaction costs in options
First of all don’t expect the cost of trading options to be in the line of what you get on FTSE rolling spreads. A spread of one point in 5,500 is only offered in highly liquid markets, not in options. If you like tight spreads, then forget options. If you are able to pay something more to get a new line of different strategies then the next few comments may help you decide on the right options to buy.
Long shots with low probability of making money, the ones that cost less, have huge spreads. That happens in fixed odds betting and also happens in financial markets. Spread betting companies put higher spreads in lower priced options. It means that you should buy higher priced options. The question that comes at this point is: which are the highest priced options? In order to answer that question, you should know what gives value to an option:
- Time to maturity – the longer the time to the expiry date, the more valuable an option is.
- Volatility: the higher the volatility of an underlying asset, the higher the price of an option
- Difference between strike and current price – the higher the difference, the higher the option value.
The cost of a one-way trip can be as high as 50, 60 or even 80% of the mean between ask and bid prices. That happens in deep out-of-the-money options and when they are near expiration. When time to maturity extends and you look for in-the-money options, spreads are tighter and can be lower than 1%. This way, in order to make the most out of your spread betting in options, look for longer maturities and more in-the-money options. Regarding volatility, the more volatile an asset is, the more expensive an option on it will be, so choose the most volatile assets. On that matter you will be ok since indices, currencies and commodities are all highly volatile. Please note, that we are advising you to buy higher priced options just because of the weigh transaction costs will have and nothing more.
Many strategies can be implemented with the use of options depending on your attitude towards risk and on your market sentiment. A covered call writing or a protective put for example, may be used when you’re bullish but don’t want to take too much risks. A naked put is a speculation in price used when the sentiment is negative and you are not concerned with the risk. There are also some strategies that play with volatility as is the case of straddle, strangle, butterfly and condor. Those strategies are very good when you think the market is highly volatile but you just don’t know the direction it will take. In that case, straight spread bets can’t help you, but options can. Since we are currently in times of high volatility, it is worth taking a deep look into volatility plays. In our next article we will look into straddles and strangles.
Which Spread Betting companies offer Options trading?
There are only a handful of spread betting companies who currently offer options trading. IG Index has the largest selection of options right now, allowing you to trade on major currencies, equity indexes and some commodities. GFT Trading started offering options trading in currencies in October 2011 – and there will no doubt be more “options” available for spread betting traders in the near future.