When it comes to stock trading, there are two types of options in the UK: Contracts for Difference (CFDs) and listed options.
CFDs and options
Both CFDs and options are derivatives. It means that their value relies on something else – the price of the underlying asset.
There are both long positions (where you buy low in the hope it gets even lower to make a profit) and short positions (where you sell high in the hope that it will get even higher before buying back to close your position at a profit).
Options are further divided into contracts for difference (CFDs), warrants, futures, forex etc., but this article focuses specifically on listed options traded on UK exchanges.
These can be identified by ‘OP’ or ‘L’ immediately following the stock’s ticker symbol on the LSE.
Listed equity options
Trading options is in some ways similar to buying/selling a lottery ticket in that you are betting on the outcome of something in the future.
If you’re right, your gains will be 100%. However, if you’re wrong, your losses are potentially unlimited as there’s no upper limit to what the stock can trade for.
One key difference between trading options and other types of the derivative is that transaction costs are often significantly lower – with any standard type of order being applicable (market orders can even be used).
It is due to three factors.
- The first two reasons mean it’s possible to place huge orders without significantly increasing slippage relative to what it would have been had you traded the underlying directly.
- The third reason is that the bid-offer spread is often lower, making a huge difference when trading large orders.
More traditional forms of derivatives typically have significantly higher costs for both entry and exit due to the need to post margin (i.e. notional * leverage).
They also usually require fairly significant slippage before any profit or loss is made because one needs to trade ‘at market’ – meaning at a price prevailing in the market at that time.
There is no warranty on where this will be unless you’re willing to wait around until a fill is obtained at the desired price point – which isn’t going to help if you want it done quickly!
For example, with an option, you can place a market order to buy (or sell) at any given time and reasonably expect it to be filled within the next few seconds.
It is impossible with futures or other, more traditional forms of derivatives that require either waiting around or using limit orders.
Trading larger quantities
The quantity traded often makes no difference to the cost, which could significantly save huge orders.
Therefore, options can offer considerably better value than many other types of derivatives simply because it’s possible to trade larger quantities without experiencing higher costs per unit traded.
It is another reason why traders seek options trading strategies that allow them to profit from smaller moves rather than just betting on whether something will go up or down significantly in one session – because they’re cheaper to trade.
One of the most attractive features for active traders is that there’s no need to post margin, which can be expensive when trading futures and other derivatives such as CFDs.
It allows you to take more positions than would otherwise be possible had you been required to post margin on every transaction.
Margin requirements also mean hedging isn’t always practicable. If markets are volatile, a trader might quickly go from a net long position to a net short position or vice versa even though they started with both trades being profitable independently of one another.
However, they were still long EUR/USD, so they decided to short it at 1.3300, which turned out to be the right decision as cable continued lower later in the session.
The initial position was closed out with a loss of 50 pips, offset by an overall profit on both other trades (75 + 25), resulting in a net gain of over 100 pips for the day – all achieved without post margin.
For more information about ETFs, CFDs, Options, and other trading terms, visit our website.