Options are contracts that give the owner the right, but not the obligation, to either buy or sell an underlying asset at a predetermined price within a specified period of time. Options are derivatives, which means that their value is based on another financial instrument (the underlying asset, which could be a stock, commodity, index, or other).
The predetermined price is known as the strike price or exercise price and it’s the most important determinant of an option’s value. This is the price at which the underlying asset can be bought (for Call options) or sold (in case of Put options) when it is exercised.
The specified time during which the option can be exercised is its expiry, which is the final date on which the option is valid. The time left until expiry is referred to as “Time to Maturity.”
What determines the price of an option?
As with any other financial instrument, the price of an option is determined by supply and demand in the market. However, the market price of the option and its value are influenced by several factors:
- Underlying price
When the underlying price goes up, keeping all things constant, Calls should gain in value because there is a higher chance for the option holder to be able to buy the underlying asset at a lower price than the market’s current value. In the same way, the value of Puts should decrease. Likewise, when the underlying price falls and everything is held constant, Put options should increase in value and Calls should drop, since the put holder has an increasing probability to be given the right to sell stock at prices above the falling market price.
- Strike price
For Call options, the higher the strike price in relation to the current underlying price, the lower the chance that the option will be valuable when exercised. Hence, Call options with a higher strike price will always be less valuable than the same option with a lower strike price. The opposite is true for Put options.
- Time to expiration
The more time there is until expiry, the higher the chance that the market will move in the option holder's favour. Therefore, the value of an option will decline more rapidly as the expiration date approaches. This is known as “Time Value.”
- Volatility
An option’s value is based on the future volatility during the life of the option. Option traders don’t really know what the volatility will be, but it can be estimated by working the pricing model backwards - this is called “Implied Volatility.” If the future volatility for the underlying asset is expected to be high - high implied volatility - the option’s price tends to increase (both for Put and Call options) and vice versa.
- Interest rate
Interest rate changes also affect the value of options. When the interest rate is increased, Put options will lose value and Call options will gain value (the opposite is true when interest rates fall).
What are option CFDs?
Option CFDs are based on the price of an option and allow you to trade on the price changes of the option. There are Options CFDs for a wide range of underlying assets, strike prices and expiry dates, just like the options traded in the market. When closing your option CFD position, you will receive the difference between the current option price and the option price when the position is opened. On the Plus500 platform, only Option CFDS are available, and they are displayed in the following manner:
Their name includes:
- The name of the underlying asset - It’s the instrument on which the options are based.
- Option type - Call or Put
- The Strike price
- Expiration date - this is the month at which the option will no longer be valid. Positions on Options CFDs will always be closed automatically at their respective expiry dates, if not closed earlier by you. You can find the exact expiry date on the instrument’s details. Note that the expiry date on the Plus500 platform is usually earlier than the expiry for the underlying option.
Why trade option CFDs?
Trading on options CFDs provides higher volatility. Options’ prices usually change more significantly than the ones in the underlying assets; therefore, they can yield higher profits, but also imply more risks.
Options CFDs also allow the opportunity to open larger positions with the same initial margin. This is because options' prices are significantly lower than those of the underlying instrument. For instance, a Call option may only cost a few dollars or even cents compared to the full price of buying a $100 stock.
Example
Let’s say you buy 10 shares of Apple at $100 each, for a total of $1000. If the stock’s price climbs to $105 and you close the position, you will make a profit of $50.
If, on the other hand, you decide to buy the same $1000 worth of Apple 110 Call option CFDs, you can buy 3000 options at $0.325 each. Then, assuming that Apple’s share price reaches the same $105, the option's price might climb to $0.7. If you close the position then, your profit will be $1125 (0.7-0.325 = 0.375 x 3000 options = 1125).
So, with the same amount invested, options can yield more profits, but could equally incur greater losses.
As you can see, options provide you with more opportunities to trade a wide array of instruments with higher volatility.
