Many are familiar with the term ‘options’ in the context of buying a car or house, but not so many understand how to trade options on listed assets. Options trading is complex and is best suited for professionals and advanced traders, but understanding the basics of options can be an exciting and valuable exercise in itself.
An option gives the holder the right to buy or sell a particular asset at a fixed price, called the strike price, until a pre-determined date called its expiry date. The two main types of options traded on London exchanges are ‘calls’ which allow their holders to buy, and ‘puts,’ which allow investors to sell an asset at a fixed price before expiration; all standardised according to the type of asset traded.
Options trading is considered riskier than buying or selling the underlying assets themselves but reduces risk due to potential profits being capped at pre-determined levels if executed correctly. This allows for option spreads – where traders simultaneously buy and sell options on the same stock to generate income from changes in price without ever having to own the stock itself – which are not possible with conventional trading of stocks.
If someone holds a call option, they have the right but not obligation to purchase 100 shares of XYZ company at £7 each before expiration. However, if they think that XYZ will reach above £7.50 within this time frame, then they may choose to exercise their option and buy at £7 (for example)
The same is true of the holder of a put option, which gives them the right to sell 100 shares of XYZ at £7 before expiration. If they expect XYZ to drop in price and wish to capitalise on that, they may choose to exercise their option and sell at £7 (for example). Alternatively, they may choose not to exercise their options and allow them to expire worthlessly.
The two major exchanges listed options that can be traded are the London Stock Exchange (LSE) and Euronext.LIFFE; with LSE focusing more on US-listed stocks such as Apple Inc., Microsoft Corp, Exxon Mobil Corp; whereas Euronext.LIFFE focuses on European companies such as BP, Royal Dutch Shell, BASF.
Here are two ways investors can trade listed options in London
Listed options in London can be traced mainly through an equity derivatives trader within a relevant investment bank. This method is done by proposing and executing the trade to another counterparty (the market maker). The trader will require a lower level of capital than if they were to do it themselves.
The process for this is that the trader negotiates with the market maker on their “bid-offer spread” for each option they offer; where the bid price is what they are willing to pay (how much they need to spend), and their offer price is how much they want for it (what they’d like to sell it at), so anything between these two prices is suitable. Market Makers in Equity Derivatives work on commission based on the volume they trade, usually in a rebate. The more trades they do, the more commission is made.
Alternatively, suppose an investor wishes to buy listed options in London. In that case, they could approach an “Execution Broker” – often found in small, private boutiques, who act as middlemen between the client and the market maker (who is also their prime broker). The Execution Broker will risk by acting as a Market Maker while not getting paid any commissions.
This allows them to keep their rates lower than if they were to pay full commission (where transactions are usually around 0.30%) but would make less money overall. This means that when dealing with Execution Brokers, one should know their actual costs before transacting.