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What Are Options?
South Africa Traders can buy & sell vanilla options (contracts) of a specific financial instrument at a predetermined time, fixed price, and fixed amount. When you trade these options, you have full control over the price you’re trading at, the underlying financial instrument, and the quantity you are trading. It is possible to trade vanilla options over the course of a day, a week, several months, and a year.
Many traders don’t know a whole lot about vanilla options. In fact, most folks prefer trading spot options over vanilla options. Truth be told, the moment you understand how vanilla options work, they are highly enticing to trade. For starters, you have a whole range of choices available, and you can control most-every aspect of these trades. By balancing risk and reward, it is possible to enjoy access to multiple financial instruments.
Important Vanilla Options Terms
Traders need to understand certain terms before trading vanilla options in South Africa. There are effectively 2 types of vanilla options:
- Call Options – with call options, the buyer has the right to purchase an instrument at a set price. Call options are purchased by traders who are bullish on the market.
- Put options, the buyer has the right to sell the specified financial instrument. Put options are typically purchased by traders who are bearish about the markets.
It is possible to buy/sell put options and call options at your leisure.
Buyers must pay sellers a premium – a specified amount to own an option. If the trader acts as a buyer of an option, he/she will pay that premium. When the trader sells that option, the trader will receive that premium. Several factors determine the premium including the price of the instrument/current rate. Since these are future-oriented contracts, the time element is important. The expiration date is known as the date at which the option can be exercised. The strike price is the price at which the option buyer can execute the trade. Options with a date in the future typically have a higher premium than options with a short-term date. Much the same is true of purchasing insurance.
Understating Market Volatility
The volatility of the financial instrument also determines the premium. When there is high volatility, the price of the option will increase. High volatility is associated with bigger market movements that can generate bigger profits. This is possible even before the option has hit its strike price. Traders can decide to close option positions at any time during the trading day. This means that you can profit from higher premiums through rising prices, or through increased volatility.
Look at the table below which illustrates how price movements on call/put options are affected:
|AN INCREASE IN:||CALL OPTIONS||PUT OPTIONS|
A Quick Lesson in Vanilla Options
When you buy a put option or a call option, you pay the upfront premium from your account’s cash balance. The potential profits are limitless. On the other hand, when you sell options, you will receive the premium upfront, and it will be deposited into your cash balance. The downside is that you may be exposed to unlimited losses if the market moves against you. This is equivalent to the losing perspective in a spot trade.
To mitigate these risks, traders have a wide range of resources available, such as stop loss orders. Other options available to you include purchasing an option further out of the money, thereby limiting your overall exposure.
When you buy options, you have limited risk. Your risk is restricted to the amount of money you spent on the premium. When you sell options (a profitable way to generate income), you act much like an insurance company. You offer protection to another trader on their position.
Once you collect the premium, the market will react according to speculative sentiment. The trader will retain the profits that he/she generated from that risk. If the trader is wrong, there is no difference to being wrong in a regular spot trade.
In any event, traders will be exposed to a potentially unlimited downside. It is possible to close out the position with stop loss orders, however with options the trader will earn the premium which is a significant advantage over spot trading.
Quick & Easy Steps for Trading Vanilla Options in South Africa
- Analyse the market perspective on your underlying financial instrument. If you believe a financial instrument will rise, you can purchase the financial instrument outright with regular spot trading.
- You can also purchase a call option. When you use this strategy, the most you can forfeit is the premium which is paid upfront. You can sell this position at any time, and this is the safest way to initiate your bullish perspective on the market.
- With vanilla trading, you can also sell put options. If the financial instrument is priced higher than the strike price at expiration, the option will not have any value, and the trader will retain the entire premium that was collected upfront.
Examples of Vanilla Option Trades
Let us assume that the EUR/GBP pair is currently trading at 1.1000. If you believe that the currency pair will rise this week, this is what you can expect:
The Spot Trade: You may open a position for 10,000 units of the EUR/GBP pair. If the EUR/GBP pair appreciates, you will instantly generate a profit.
Purchase Call Option: In this instance, you may buy a call option with a week until it expires, at a strike price of 1.1020. You will pay the premium as per the trading platform – 50 pips or 0.0050. If at expiry time the EUR/GBP pair is greater than the strike price, you will earn the difference between the prevailing rate of the EUR/GBP pair and the strike price. Your breakeven level will be the strike price + the premium you paid initially. You can generate profits at any time before the expiration date of the option because of the increase of the implied volatility of the pair. The higher the EUR/GBP pair moves, the greater the profits you will generate.
Another example will clarify this further: If the pair expires at 1.1100, your option will be 80 pips in the black, otherwise known as in the money. The profit you generate will be equivalent to 80 pips less the premium of 50 pips. Alternatively, if the spot price is less than the strike price at expiration, your loss will be capped at your premium of 50 pips.
Remember, your losses will always be limited to what you paid if the spot is less than the strike price at expiration.
Selling Put Options: In this instance, you can sell a put option. This means that the trader – you – will receive the premium directly into your account. You assume a level of risk as a seller, if you are mistaken about market movements. Choose the strike price carefully. You should be comfortable with your perspective that the EUR/GBP will not move lower than the strike price at expiration.
Seen from a different perspective, you should be entirely comfortable buying the EUR/GBP pair at the strike price. If the spot price ends lower, you (the seller) have the right to exercise a put option on the EUR/GBP pair at the strike price. You will receive the upfront premium in return for taking the risk as an option seller. If the strike price is less than the spot price, you get to keep the premium and you can sell another put option for free. This adds further income to your account balance.
In both cases, the market determines the premium. As you can tell from the AvaOptions trading platform at the time the trade is concluded, all gains/losses are based on the strike price of the underlying instrument. They will further determine the rate of the financial instrument at expiry time.
Why Trade Options?
- Risk management
At the end of the day, it is considered a safe investment in fact, for an option buyer, they are far less risky than FX trading the underlying. For a seller, the downside risks, too, are less than that of being wrong on a spot trade, as the option seller gets to set the strike price according to his risk appetite, and he earns a premium for having taken the risk. Options do require an initial investment of time, to get to know the product.
- Express any market view
Perhaps the most unique advantage of options is that one can express almost any market view, by combining long and short call and put options, and long or short spot positions. The trader is bearish on USDJPY, but not sure? He can buy a put option for his target expiration date, sit back and relax. Whether USD-JPY goes up or down tomorrow, he is safe in his position all the way to the expiration date. If he turns to be right, spot is lower than the strike price by at least the premium value, he will earn profits.
- Multiple Strategies
Like any instrument, trading options has its risks and potential losses. However, there is a major difference between trading spot and trading options. In spot trading the trader can only speculate on the market direction – will it go up or down. With options, on the other hand, he can execute a strategy based on many other factors – current price vs strike price, time, market trends, risk appetite, and more, i.e. he has much more control over his portfolio, and therefore more room for manoeuvre.
- Learning Center
Options are a great tool for any trader who invests just a little time to understand how they work. AvaTrade South Africa offers a full education section accessed directly from the trading platform.
- Increased trading choices
For an experienced and aggressive trader, options can be used in a myriad of ways. For the beginner trader, or a more conservative trader, long options strategies such as buying options and option spreads, offer a limited risk entry into the market. By using the products and tools offered on the AvaOptions platform wisely, this flexibility generates more possibilities for making profits.
The Intrinsic Value of a Vanilla Option
Once an option is created it will always have an intrinsic value. These are expressed by the terms “in the money”, “at the money”, and “out of the money”.
An option that is in the money has a positive intrinsic value because the strike price of the option is favorable when compared to the actual market price of the underlying asset.
- In the case of a call option, in the money means the holder is able to purchase the underlying asset below the current market price.
- In the case of a put option, in the money means the holder is able to sell the underlying asset at a price above the current market price.
Note that in neither case does being in the money mean that the trader has a profit from the trade. It’s also necessary to consider any expenses associated with the purchase of the option such as commission fees or spreads.
If the strike price of an option and the market price of the underlying asset are the same the option is said to be at the money. This means there is no value to the option as it is in equilibrium with market prices.
It is also possible for an option to be considered out of the money if the strike price is not favourable when compared with the actual market price.
- In the case of a call option, out of the money means the strike price of the option is higher than the market price of the underlying asset and the option currently has no intrinsic value.
- In the case of a put option, out of the money means the strike price of the option is lower than the market price of the underlying asset and the option currently has no intrinsic value.
Options are often out of the money because the price of the underlying asset hasn’t had time to move enough to make the option profitable. Options that are out of the money typically have lower premiums than at the money or in the money options.
So the cost of an option or the price paid will depend on whether the option is in the money, at the money, or out of the money. There are other factors that can influence the premium of an option, including the volatility of the underlying asset, and the time left until the option expires. Greater volatility and a longer amount of time until option expiration both offer the chance for an option to move in the money before expiring, and thus the premium cost of the option is increased.
What Are the Benefits of Trading Options?
- Migrate Risk
Options are regarded as safe investments. In fact, options buyers regard them as less risky than trading the underlying asset. For sellers, the downside risks are less than being on the wrong side of a spot trade. The option seller sets the strike price based on his/her appetite for risk. The seller will also generate a premium for taking that risk. Traders should understand the underlying financial instrument when trading options.
- Take a Bullish/Bearish Perspective on Markets:
With options trading, you can go long or short on financial instruments at your leisure. If you are bearish on the GBP/USD pair, you can buy a put option based on your target expiration date, and wait for the trade to finish in the money. Regardless of the direction of price movement of the GBP/USD pair tomorrow, you are safe up until the expiration date. If you end up being correct, and the spot price is lower than the strike price by the premium value, you will generate profits.
- Wide Variety of Trading Options
Experienced traders have many ways to use options. As a novice, you may likely be a conservative trader and prefer long strategies such as buying option spreads. These offer limited risk entry for newbies to the financial markets. AvaOptions provides you with a wealth of options based on your specific risk appetite and trading preferences. This naturally results in greater profit potential possibilities for you.
- Execute Multiple Strategies
All financial instruments are associated with risks for profits and losses. The difference between trading options and trading spot is that with the latter you simply speculate on the direction of market movement. In other words, will the markets rise or fall. When you trade options, you can implement a trading strategy based on a myriad of factors. You can take the current price versus the strike price, your appetite for risk, market trends and movements, and other factors into consideration. You have greater control over your financial portfolio, and more room for maneuverability.
- AvaTrade Learning Center
When trading vanilla options at AvaTrade South Africa, you have access to a full education section direct from your trading platform. This is a premium benefit available to all registered traders.
There are two other types of options that can be purchased and they are often combined with vanilla options to create a specific outcome. The first of these are known as exotic options, which add certain conditions or calculations to their execution. One example are the barrier options which include a trigger level.
If the trigger level is reached the option can either come into existence or cease to exist. Another type of exotic option is the digital option, which pays out to the owner of the option if the price of the underlying asset trades above or below a specified level. A third type of exotic option is the Asian option, whose payoff is tied to the average trading price of the underlying asset during the full life of the option.
AvaTrade Vanilla Options Trading
As the South Africa’s leading options trading platform, AvaTrade prides itself on delivering world-class FX trading facilities to our clients. Our customer-centric approach ensures that a wide range of trading tools and resources is available to you at the click of a button. We will guide you and assist you throughout your trading sessions. Simply download MT4 OR MT5 (MetaTrader) the most sophisticated and popular trading platform on the market. You can start trading options at the click of a button. Choose the display that best matches your preferences, with a range of tools designed to help you profit from the financial markets.
Vanilla Options main FAQs
What assets can I trade with vanilla options?
There are a huge variety of assets that have vanilla options associated with them. The best known are the stock vanilla options, but you will also find vanilla options available for commodities like gold and crude oil, currencies, bonds, and a host of other assets. This can make it far easier for traders to hedge strategies that might otherwise present too much risk. Both call and put options can be purchased for all the different assets that have vanilla options.
Are vanilla options a good choice for beginners?
Vanilla options are one of the more straightforward types of financial derivatives, so they can be used by novice traders without too much additional risk. They might not be suitable for someone who has never traded before in their lives, however for those who do fully understand the risks involved with vanilla options there’s no reason not to use them as one part of a trading strategy.
What does it mean when an option is “in the money”?
In the money options are those that have an intrinsic value. In other words, the option has a value because the strike price is favourable compared with the actual market price of the asset. An in the money call option means the holder has the opportunity to buy the asset below its current market price. An in the money put option means the trader has the opportunity to sell the asset at a price above the current market price. An in the money option doesn’t automatically mean the trader has a profit either. You must also factor in any trading costs and fees.