Today, we will introduce you to option volatility and how you can use it to your advantage.
In this article, we will discuss the following:
- What is option volatility?
- Who uses option volatility?
- Types of options available in the UK.
We will also cover the key factors that affect an options price/value, implied volatility and time decay.
Types of UK options available
To begin with, though, let’s take a look at the three types of UK listed options available for trading on Admiral Markets MT4 account: Outrights, Pairs and Options Futures.
Outright, pairs and options futures
An Outright is an option with a single strike price, while the Pairs are two strike prices, which can be bought/sold to take advantage of any price movement between them.
The third type is Options on Futures, where the underlying asset is not an individual share or commodity but a future contract for that asset.
We will discuss this last type today because 70% of all listed options trading in the UK are futures-based. That’s over £45 billion traded every year.
What exactly does an option represent?
A Buyer of an option contracts the right to buy or sell an agreed amount of the underlying share, index, commodity etc., at a pre-agreed price no matter how high or low its market value goes.
It is hugely advantageous to the buyer, as he is guaranteed the right and obligation to buy or sell at a set price regardless of what happens in the future.
If you already own shares within that Future Contract, this guarantee can be essential because it will protect you from losing money if they go down in value.
Options on futures
An Option on Futures works like an Outright option (see above), except that instead of each Outright representing one asset (stock) under contract; Each Future contract represents a massive amount of that asset, say 1000 shares in this case.
That means you can buy or sell not just one share but 1000, for example. It works the same way as buying an Outright option, where you commit to purchasing/selling a predetermined number of shares at a predetermined price by expiry date.
The only difference is the actual underlying asset the option contract is based on.
Optional futures are traded within the term structure, displayed in’ weeks’ periods. For example, one week might be three months, another maybe nine months etc.
This term structure changes every Friday afternoon and will show how many weeks remain until expiry.
How are futures contracts priced?
Each week that a Future underlying contract has remained until expiry, its option price is recalculated to show the value of just one week.
It effectively means that it will ultimately increase or decrease in value each week, depending on how much volatility there is within the market.
If, for example, there is a lot of volatility, then the options will become more expensive because traders are prepared to pay more for insuring themselves against this increased downside risk by buying Optional futures based on the underlying asset.
Likewise, if there’s no volatility at all, then all Options are worthless because you are paying less money to buy that insurance guarantee protecting you from loss if prices go down.
Of course, prices fluctuate markedly in actual life, which makes this strategy so powerful and profitable.
When to use options on futures?
As we said before, when there is a lot of market volatility, traders will be prepared to pay more for options (insurance) because they know their investment is at a much higher risk.
Of course, the opposite holds, too; if markets are becalmed with hardly any price movement, then option premiums drop significantly.
So these are the times you would want to trade if you have an appetite for risk because your chances of making money are vastly increased during periods of high volatility compared to very low volatility.
You can visit our website for more information about trading terms such as CFDs, ETFs, options, forex, and much more.
