CFD Options Trading: How to Trade Options CFDs?

Navigating CFD options trading may seem daunting to some, but understanding its fundamentals can make it more accessible.

These contracts’ underlying assets are options, contracts granting the right to buy or sell an asset at a set price within a specific period. They derive value from underlying assets like stocks or commodities and serve purposes such as risk hedging.

This article aims to simplify these concepts, exploring their mechanics and strategies to empower you to make a great start on your options trading journey.

What Are Options & How Do They Differ From CFDs?

To understand the dynamics governing CFDs on options, let’s first dive into a few fundamental features of traditional options, which differ from options CFDs.

Firstly, options CFDs do not grant ownership of the underlying asset at the point when a trader opens a position or thereafter. In contrast, a traditional option is essentially a contract that grants the holder the right, without the obligation, to either buy (in the case of a call option) or sell (in the case of a put option) a specified amount of an underlying asset at a predetermined price on or before a specified date. These contracts are utilised for various purposes, including generating income, speculative trading, and hedging against risk. Furthermore, it is important that traditional options fall into the class of financial derivatives, as they derive their value from an underlying asset, which could be stocks, bonds, currencies, or commodities.

Applications of CFD Options Trading

When used strategically, options CFDs can augment a trader’s portfolio by providing additional exposure to various underlying asset classes.

For instance, investors can use option CFDs to hedge their portfolios against potential losses in a declining market. By employing put option CFDs, investors can limit their downside risk while retaining the opportunity to benefit from upward market movements. Conversely, call option CFDs can serve as a hedge for short sellers, limiting potential losses if the market moves against their positions, particularly during short squeezes.

In addition to risk management, options CFDs trading also facilitates exposure speculation on future price movements. Speculators may anticipate the price of a particular underlying asset to increase based on fundamental or technical analysis. Instead of directly purchasing the asset, or the option itself, they might opt to buy a call option CFD, attracted by the leverage options provide. With only a fraction of the cost compared to buying the underlying asset outright, speculators can gain exposure to the potential price movements.

Options CFDs fall within the broader category of derivatives, whose value is derived from the price of an underlying asset. This classification includes various financial instruments like futures, forwards, swaps, and mortgage-backed securities, alongside options.

In essence, CFD options trading offers investors a versatile toolset to help manage risk and speculate on market movements. By understanding the principles underlying options contracts and their applications, investors can harness their potential to optimise investment strategies on related CFDs and help achieve their financial objectives.

However, when entering the world of CFD options trading it is important to weigh the risks against the potential benefits. CFD options can be extremely volatile, and given that they are traded with leverage, the potential for significant financial losses is always present in this market.

How Does Options Trading Work?

CFD options trading, while not offering ownership of the underlying asset, is closely related to the trading dynamics of options themselves, so comprehension of the various factors affecting options trading is crucial.

When it comes to assessing the value of option contracts, the primary focus is on evaluating the likelihood of future price movements. Essentially, the more probable an event is, the higher the cost of that option that benefits from that event will be. For example, the value of a call option rises as the underlying stock price increases, illustrating the fundamental principle underlying options valuation.

As the expiration date approaches, the value of an option diminishes. This is attributed to the decreasing likelihood of significant price changes in the underlying stock as time passes. Consequently, options are deemed "wasting assets" because their value diminishes over time, especially if they are ‘out of the money’, i.e. the call option’s strike price (predetermined sell or purchase price) exceeds the underlying asset’s current market price which would result in a loss if sold. Consider a scenario where a one-month option fails to experience a significant stock movement; in this case, the option progressively loses value with each passing day. Therefore, options with longer expiration periods hold more value compared to those with shorter durations, as they generally provide more time for favourable price movements to occur.

This phenomenon, known as time decay, underscores the importance of time in option pricing dynamics. Consequently, an option with a year until expiration will command a higher price than a similar option with only a month left until expiry. Essentially, the value of an option today exceeds its anticipated value in the future if the stock price remains stagnant.

Moreover, volatility significantly impacts options prices. Higher volatility levels increase the uncertainty surrounding future price movements, thereby elevating the probability of significant price fluctuations in either direction. Consequently, heightened volatility generally translates to increased option prices. This intrinsic relationship between options trading and volatility underscores the importance of understanding and managing volatility risk in options strategies.

On most U.S. exchanges, a standard stock option contract represents the right to buy or sell 100 shares. Therefore, to determine the total cost of purchasing a call option, one must multiply the contract premium by 100.

In practice, option investors often choose to realise their profits by closing out their positions in the market. This involves selling options for holders and buying back positions for writers. Only a minority of options, approximately 10%, are exercised, while the majority, around 60%, are traded or closed out, with the remaining 30% expiring worthless.

The fluctuation in option prices can be attributed to intrinsic value and extrinsic value, commonly referred to as time value. The premium of a given option can be understood as the combination of the contract’s money value, its intrinsic value, and its time value, which is what the option is worth beyond the intrinsic value. Thus, option pricing can be conceptualised as the sum of intrinsic value and time value.

In reality, options typically trade above their intrinsic value due to the inherent probability of future events, however unlikely they may seem. This ensures that options carry a certain level of value, even in situations where the occurrence of an event is highly improbable.

Options Trading Strategies: Calls vs Puts

In recent years, the volume of options trading has increased significantly. This surge underscores the growing prominence of options trading, particularly in the wake of the pandemic, where investors of all backgrounds have increasingly turned to this financial instrument.

Despite the burgeoning popularity of their underlying assets, options CFD trading often presents a perplexing landscape for everyday investors. However, understanding the distinction between call and put option CFDs serves as an essential starting point for demystifying this realm.

Puts and calls serve as fundamental building blocks in options trading, with seasoned traders and investors having incorporated them into their strategies for decades. However, the surge in options trading interest during the pandemic, coupled with the accessibility of user-friendly brokerage platforms like Robinhood, has further popularised options trading, attracting millions of new participants to the market.

Call Option CFDs

These are CFDs based on call options, which are typically utilised when there is an expectation of a stock's upward movement, while put options are favoured when anticipating a decline. Despite this conventional usage, options offer flexibility, allowing investors to express both bullish and bearish sentiments through various strategies tailored to specific market conditions.

When opening a position on a call option CFD, the trader should take into account the nature of the underlying instrument, the expiry date, and the strike price. For example, Meta | Call 300 | Jul is a contract based on a trader’s prediction that Meta’s share price will be above $300 in July. The underlying instrument is Meta shares, the call price is 300, and the expiration is in July. The CFD trader opening a position on this contract will make a profit if Meta’s share price is above $300 at the time of expiration, but will lose money if it trends in the opposite direction.

Put Options CFDs

Put option CFDs function as speculative financial instruments allowing traders to get exposure on the price decline of an underlying asset without owning it. When trading on a put option CFD, the trader speculates that the price of the underlying asset will decrease within a specified time frame. Unlike traditional put options where the buyer has the right to sell the underlying asset at the strike price, in the CFD market, the put option CFD holder does not have the right to sell the asset but rather aims to profit from the difference between the opening and closing prices of the option. If the price of the underlying asset falls below the strike price by the expiry date, the put option CFD holder can potentially profit.

Conversely, if the price remains above the strike price or the anticipated decline doesn't occur, the trader may incur a loss based on the difference between the opening and closing prices o fthe option. Put option CFDs provide traders with flexibility and the opportunity to benefit from downward price movements in various financial markets, although the risk of equivalent losses is always present as well.

Overall, put option CFDs serve as versatile financial instruments, offering investors opportunities for risk management, speculation, and portfolio diversification in volatile market conditions. Understanding the dynamics and applications of put options is essential for investors seeking to optimise their investment strategies and navigate the complexities of the market surrounding CFDs with this class of options as their underlying asset.

In summary, call options CFDs are sought after to capitalise on upward movements in stock prices, while put options CFDs provide a means to profit from downward movements. Understanding the dynamics between these two types of underlying options is crucial for navigating the complexities of options CFD trading, as contracts for difference based on options are tightly linked to the underlying assets’ market dynamics.

How to Trade Options CFDs: Step-by-Step Guide

Here’s a guide to making your jump into the complex world of options trading as smooth as possible:

Step 1: Open Trading Account

To trade options CFDs, the first step is to open an account with Plus500 via our site or platform and complete the verification process.

Step 2: Research Your Chosen Options

When making your CFD options trading choices, it is crucial to consider several factors which may influence your decision. Key among these important variables are the contract’s strike price, time value, as well as the volatility associated with the contract’s underlying asset.

Step 3: Predict Strike Price

When selecting an option CFD, it's vital to make an assessment regarding the strike price. The strike price is the price at which the underlying option holder can execute the transaction. Intrinsic value and time value influence the price you pay for the option CFD. Intrinsic value represents the difference between the stock price and the strike price, while time value accounts for factors such as volatility, time to expiration, and interest rates.

Step 4: Determine the Time Frame

The options contracts on which these CFDs are based have expiry dates. Depending on your trading strategy and risk tolerance, choose an expiration date that aligns with your investment philosophy. Additionally, consider the expiration period's impact on the underlying option's price—the longer the expiration, the higher the cost, but it also allows you more time to fine-tune your trading strategy.

These steps provide you with some useful tools to help you on your options CFD trading journey. Remember to conduct thorough research, utilise available resources, and practice risk management to increase your chances of trading success.

Pros and Cons of CFD Options Trading

When trading CFD options, it’s best to gain a general understanding of the advantages and disadvantages offered by the underlying asset in order to deeply comprehend their trading dynamics. Options CFD trading offers both advantages and disadvantages for investors, each with its own set of considerations. Let's delve into the pros and cons of options CFD trading to gain a comprehensive understanding of this investment strategy.

CFD Options CFD Trading Pros

One of the primary advantages of options CFD trading is the higher exposure than that offered by other financial instruments. For example, leverage of 1:5 makes it possible for a given trader to trade on $5,000 of options CFDs after having deposited 1/5th of that amount, or $1,000.

Furthermore, trading options CFDs with Plus500 also come with the ability to use risk management tools to better navigate this volatile trading arena.

CFD Options Trading Cons

On the other hand, because options CFDs generally offer greater leverage, the potential for significant financial losses increases in tandem with that of gains. The options CFD trader must also maintain a high awareness of the various factors affecting price movements. These can include market volatility levels, the difference between the underlying instrument’s current price and strike price, as well as overall supply and demand. With options CFDs carrying the risk for significant financial losses, keeping track of these variables is highly important.

CFD Options Trading Tips

A few key points are important to keep in mind when engaging in CFD options trading. Here we have some tips that might prove useful:

• The world of CFD options trading can be overwhelming, but developing a trading plan is essential for navigating this complex landscape. First of all, it's advisable to set clear goals. Determine what you hope to achieve through options CFD trading, whether it's to speculate on asset prices, protect existing positions, or diversify your portfolio. Once you've established your objectives, select an appropriate trading strategy that aligns with your goals. Whether you have a bullish, bearish, or neutral outlook, there are various strategies to suit your needs.
• Setting your personal entry and exit points is crucial for managing risk and maximising profits. Determine the conditions under which you'll enter and exit trades, whether it's based on technical/fundamental analysis, personal trading goals, or a combination of any other factors. Consider taking advantage of buy and limit orders to execute your trades. Additionally, monitoring the intrinsic value of your options to assess their profitability can help make informed decisions about when to exit positions.
• When placing options CFD trades, you may wish to select contracts on options related to assets with high trading volumes and liquidity. Select option CFDs that align with your outlook and risk tolerance, taking into account factors such as the associated strike price and date of expiry among other things. Whether you're buying or selling options CFDs, stay true to your trading strategy and objectives.
• Managing open positions requires ongoing monitoring of market conditions and option prices. Stay vigilant and attentive to changes in underlying asset prices, volatility, and investor sentiment among other things. Adjust your strategy as needed to adapt to evolving market dynamics and maximise returns. Remember that CFD options trading requires a high level of detail orientation and awareness of short-term market movements.
• To succeed in CFD options trading, also consider investor psychology and market sentiment when making trading decisions. Track sentiment trends and news alerts to anticipate market reactions and adjust your strategy accordingly. Additionally, commit to your trading approach and stick to your plan, avoiding impulsive decisions based on emotions or short-term fluctuations. Conduct thorough research, back-test your strategies, and practise disciplined trading to improve your chances of success in the options market.

Conclusion

In conclusion, while CFD options trading presents both opportunities and challenges, understanding the fundamentals and strategic applications of the underlying options can empower investors to navigate this complex financial landscape. CFD options offer unique advantages such as income generation, risk hedging, and portfolio leveraging. By grasping the principles discussed in this article, investors may become better poised to wisely engage with CFD options trading. However, it is always crucial to remember that due to the generally high leverage available when trading CFD options, the risk of financial losses is ever-present.

Options Trading FAQs

What’s the difference between futures and traditional options?

The key difference between futures and options is that futures contracts obligate the buyer to follow through with his or her purchase at the predetermined price and date, while options are more flexible as they merely grant the trader the option to do so.

What is the strike price of an option CFD?

The strike price is the price of an option CFD’s underlying asset.

What Is the Difference Between American Options and European Options?

European-style options contracts can only be exercised at the expiration time, while American-style options contracts can be exercised at any time prior to expiration.

What Are the Key Characteristics of Options CFDs?

The key characteristics of options are their flexibility, diverse nature, and leverage.

What Does Exercising an Option Mean?

Exercising an option denotes buying the underlying asset at the agreed-upon time and price.