An options corner special from GFT Markets – Options: Which strike?

Option traders often have difficulty determining which strike to choose. They have a directional view and a target level but fail to execute the best trade in terms of efficiency. When trading options the considerations should be: margin, premium and expected profit at the target level.

Here are some example trades. They each have the same view: FTSE to reach 7200 by October (2 months away). The FTSE is currently trading at 6812. Each person has £2,000 in their account.

Buying an option:

If we are expecting the market to go up then we could buy a call option.

Ed buys £40 per point of the FTSE Oct 6900 call at a price of 49.

Frank buys £108 per point of the FTSE Oct 7000 call at a price of 18.5.

Georgina buys £333 per point of the FTSE Oct 7100 call at a price of 6.

Assuming FTSE is at the target of 7200 for the October expiry the profits will be quite different.

Ed: The 6900 call will expire at 300 (7200 – 6900) giving a profit of 251 points x £40 per point = £10,040.

Frank: The 7000 call will expire at 200 (7200 – 7000) giving a profit of 181.5 points x £108 per point = £19,602.

Georgina: The 7100 call will expire at 100 (7200 – 7100) giving a profit of 94 points x £333 per point = £31,302.

With hindsight the 7100 call was the most profitable option to have bought. Below is a plot of the profits of a range of strikes. We can see it’s important not to choose a strike which is too high as the profits tail off fast. The 7150 call for example would only have given a profit of £23,000.

It is however important to understand that the above profits only occur if FTSE is at 7200. If FTSE were to finish at 7100 then the profits would be as follows:

6900 call: £6,040

7000 call: £8,802

7100 call: £1,998 (loss!!)

This demonstrates how crucial it is for the market to hit your target. Buying options will mean you can never lose more than the premium you paid for the option.

Selling an option:

If we are expecting the market to go up then we could sell a put option. Each of the trades below requires £2,000 of margin in a GFT account. This is NOT the maximum loss as it is possible to lose more than this when selling options. Margin at other spread bet providers could be different.

Ed sells £227 per point of the FTSE Oct 6200 put at a price of 8.5.

Frank sells £121 per point of the FTSE Oct 6400 put at a price of 19.

Georgina sells £75 per point of the FTSE Oct 6600 call at a price of 42.

If FTSE reaches the 7200 target at expiry then the profit is equal to the premium.

Ed: makes £227 x 8.5 = £1,930

Frank: makes £121 x 19 = £2,299

Georgina: makes £75 x 42 = £3,150

If the FTSE reaches 7100 then the profits would be the same. In fact FTSE can actually move against the three traders (they will need to ensure they have enough capital in their account as their margin is likely to increase and so might the price of the option they sold… leading to running loses). The FTSE could drop all the way to 6600 and the profits would be the same.  However if the FTSE drops further the losses could become quite large. For example if the FTSE is at 6000 at expiry:

Ed: loses £227 x 191.5 points = £42,470 (loss!)

Frank: loses £121 x 381 points = £46,101 (loss!)

Georgina: loses £75 x 558 points = £41,850 (loss!)

Given the size of these loses traders will need to either close out or reduce their position or add more funds to their account.  They must also bear in mind the speed of a potential drop. If it’s fast the margin is likely to increase significantly. All these could lead to greater losses than the £2,000 in the account.

GFT are currently the only spread bet provider to allow stops and limits on options. Leaving stops could help to keep the potential losses under control. But there is still the chance of slippage on stops on the market open (at 8am for FTSE) so this is in no way a guaranteed cap on losses.