Breaking down the basics of listed options: a must-read for intermediate traders

Understanding the basics of listed options is essential for intermediate traders to become successful investors. The trading world can be complex and intimidating for those unfamiliar with the terminology and regulations. However, knowledge on this topic is vital to gaining an edge in the stock market. This article will explore fundamental concepts related to listed options that every UK-based trader should know about to improve their chances of turning a profit.

What are listed options?

Listed options are a form of derivative security that gives the holder the entitlement to buy or sell an underlying asset at a set price by a predetermined date. The underlying asset can be stocks, bonds, commodities, currencies, indices, etc. Options can be both call options or put options. Options contracts are generally sold in standardised contract sizes and terms on regulated exchanges such as the London Stock Exchange. Investors purchase these contracts to take advantage of potential price movements without committing large amounts of capital upfront. Traders set up strategies using listed options with various expirations and strike prices to achieve their desired outcome.

Characteristics of listed options

Listed options have specific characteristics that make them attractive to traders. These include their ability to limit downside risk, the potential for significant returns on investment and minimal initial capital outlay.

Limited downside risk

The main benefit of trading options is that the downside risk of a position can be limited. Options are like insurance policies against market movements, giving the holder the authority to buy or sell an underlying asset at predetermined prices and times. Therefore, even if the stock or commodity goes down in price, you can still exercise your option and make a profit if you correctly predicted the direction of the price movement. This feature is desirable to traders who are still determining market conditions but wish to participate in the stock market. Traders can check out Saxo Markets to see live market conditions.

Potential for significant returns on investment

Options can also offer investors generous returns when done right. Depending on the option type, traders can potentially make up to 100% return on their initial investment in a single trade. It is achievable because options are leveraged instruments and only require a small portion of capital upfront. It allows investors to benefit from more significant price swings with much less risk than if they had invested directly in the underlying asset. However, investors should also remember that trading involves risk and profits are never guaranteed.

Minimal capital outlay

Options also allow investors to enter positions with minimal capital outlay. Since most options contracts are traded on regulated exchanges, traders need only put up a fraction of the total investment to buy them. It allows them to benefit from more significant price swings than if they had invested directly in the asset. Additionally, since options contracts are standardised, they can usually be bought and sold on exchanges without any negotiation process.

Options trading strategies

Options can be used to construct various trading strategies tailored to the individual investor’s goals and risk appetite. The most favoured options strategies include covered calls, spreads, straddles, and butterflies. Remember to do thorough analysis before placing a trade.

Covered Calls

A covered call is an options strategy whereby an investor buys shares of stock to sell call options against them. The idea is to benefit from any potential upside movement in the underlying asset while collecting premiums on the sold calls. This strategy allows traders to generate income without taking on too much risk as they own the underlying asset that they are selling calls.

Spreads

A spread is an options strategy where two or more options contracts with different strike prices or expirations are bought or sold in the same transaction. The idea here is to benefit from changes in implied volatility (the uncertainty surrounding an asset’s price) while limiting risk.

Straddles

A straddle is an options strategy where two contracts with the same strike price and expiration date are bought to benefit from large movements in either direction. This strategy works best when significant volatility in the underlying asset allows traders to take advantage of increased market uncertainty.