Options Trading vs CFDs
Reading time: 11 minutes
In this article we will explain options trading for beginners, starting with options trading basics, along with an options trading example. We will also discuss the pros and cons of options trading, and whether or not other products, such as CFDs (or Contracts for Difference), are more suited to traders in today's market.
What is Options Trading?
Options trading is a form of speculation on an underlying asset. These assets could be a stock, a bond, a commodity, or any other type of trading market. Because of this, they are known as 'derivative' products, as the price of an option is derived from the price of the underlying asset. Options trading originated in ancient Greece, where individuals would speculate on the olive harvest. Nowadays you can learn options trading and use options trading strategies across most markets such as Forex, stocks, commodities, bonds, and stock market indices.
For those who do participate in online options trading, one of the most popular methods is stock options trading. In online options trading, if you purchase an options contract, it grants you the right, but not the obligation to buy or sell the underlying asset at a set price before or on a certain date in the future. In this way, it is very similar to other forms of speculation in terms of picking the direction you believe that the market will move. However, because options contracts have expiration dates, the trader also needs to think about how long the market will keep moving in their direction, as well as the expected volatility of the move. For now, let's focus on the two types of contracts available when trading options - calls and puts.
How Does Options Trading Work?
When you begin to learn options trading, the first element to learn is the two types of options contracts available. They are called 'calls' and 'puts'. It's important to remember that there are always two sides to every option transaction - the buyer of the option contract, and the seller of the option contract (known as the writer). While you can use options on most financial markets, let's stick to stock options trading for now.
Options Trading Basics: What is a Call Option?
Buying a call option gives the buyer the right, but not the obligation, to purchase the shares of a company at a predetermined price (known as the strike price) by a predetermined date (known as the expiry). The seller of the call option (known as the writer) is the one with the obligation. This is because if the call buyer decides to take the option to buy the shares (known as exercising the option), the call writer is obligated to sell their shares to the buyer at the predetermined strike price.
Let's suppose that a trader bought a call option on Apple with a strike price of $180, which was due to expire after six weeks. This means that the trader buying the call option has the right to exercise that option (meaning, the right to buy the shares), by paying $180 per share. If the price of Apple's shares goes up to $200, then exercising the option is a good deal for the buyer - they are able to get the shares at a lower price than they would pay on the open market.
The writer of the call option would then have the obligation to deliver those shares for $180 per share, no matter what the actual underlying price of Apple is. If the price of Apple's shares falls to $150, on the other hand, the buyer has no obligation to exercise the options contract. In this case, the buyer would let the contract expire, and the writer would hold on to their shares.
Options Trading Basics: What is a Put Option?
Buying a put option provides the buyer the right, but not the obligation, to sell the underlying stock at a predetermined strike price, by a predetermined expiry date. In this instance, the trader is betting on a fall within the stock price, and is essentially shorting (or short selling) the market. Let's take a look at a stock options trading example:
Let's say that Tesla is trading at $360 per share (which is also the strike price), and the price of a put option at this strike price is $6 per contract, which expires in three months time. As one option contract equals 100 shares, the cost of 1 put is $600 (100 shares x 1 put x $6) - this is also known as the option premium. The trader's breakeven price is the strike price minus the price of the put. In this instance, the sum would be $354 ($360 - $6).
If at the expiration date of the contract, the underlying stock price of Tesla is trading between $354 and $360, the option will have some value, but will not show a profit. If the share price remained above the strike price of $360, the option would then become worthless, and the trader would lose the price paid for the put (which was $600). If the share price traded below $354 and lower, the trader would begin to be in profit.
How to Trade Options: Options Trading Strategies
Options are tradable securities, meaning that very few options actually expire and see shares transferred. This is because most traders are merely using them as a vehicle to speculate on the price movement of the underlying asset. However, not all options follow the magnitude of price movement of their underlying assets. This is because the value of an option decreases over time, which leads to characteristics that are fundamentally different than just buying a stock.
This may sound strange but it is just one reason, among many, why beginner traders lose money in options trading. That's why, when using options trading strategies, it's important for traders to understand 'the Greeks' - Delta, Vega, Gamma and Theta. These are statistical values that measure the risks involved with trading an options contract:
- Delta: This value measures the option's price sensitivity to changes in the price of the underlying asset. Essentially, it is the number of points the option price is expected to move for each one point change within the underlying asset. A one point move in the underlying asset will not always equal a one point move in your option value. The delta values range from 0 and 1 for call options, and 0 and -1 for put options.
- Vega: This value measures an option's sensitivity to changes in the volatility of the underlying asset. It represents the amount an option's price will change in response to a 1% change in the volatility of the underlying market.
- Gamma: This value measures the sensitivity of the delta value in response to price changes within the underlying instrument.
- Theta: This value measures the time decay of an option. The closer the option moves to the expiration date, the more worthless it can become. Theta measures the theoretical dollar value an option loses each day.
As you can see, there is a considerable amount to consider when trading an options contract. This is on top of the analysis required to locate a profitable trade, to analyse the direction, and to find possible areas to buy or sell, and where to exit. The complexity of options trading is just one reason many traders have turned to other products to speculate on the financial markets with, such as CFDs (Contracts for Difference).
Why Options Traders Should Consider Trading CFDs
A CFD, just like an option, is also a derivative product that enables traders to speculate on the rise and fall of a market. When trading a CFD, it is essentially a contract between two parties, the buyer and the seller. It stipulates that the seller will pay the buyer the difference between the current value of a market, and the value when the contract ends.
In this instance, the seller is usually your broker. With a CFD, the trader simply pays the difference between the opening and closing price of the underlying market. Unlike options trading, where a one-point move within the underlying asset doesn't always equal a one-point move in the options contract, the CFD tracks the underlying much more closely. Here are some key differences between options trading and CFD trading:
Contract expiry dates - the market may keep moving in your favour after your option expires, therefore you cannot profit from the move
Generally no expiry dates
Not all shares and instruments are available to trade on with options
Traders can trade over 3,000+ markets
Option writers are exposed to unlimited losses
Traders can use stop losses and volatility protection orders to manage risk
Value of options declines over time and they are regarded as 'wasting assets' due to time decay
No time decay on a CFD contract - get the full profit or loss
Option traders must have a minimum of $2,000 in their trading accounts at all times as an industry requirement, with a minimum of $25,000 when day trading options
Traders can open a CFD account with just $200
There are also some distinct features of trading CFDs such as:
- Leverage: Retail traders can trade positions that are up to 30 times their account balance (depending on the instrument) thanks to leveraged trading. A professional trader can trade positions 500 times their account balance (If you would like to learn more, make sure to check out Admiral Markets' Retail & Professional Terms').
- Trade in any direction: Go long or short on any market, and take opposing trades to hedge your exposure with certain accounts.
- Hold trades as long as you want: With CFDs you can trade in and out of markets within seconds, or you can choose to hold positions for days, weeks, or months.
- Advanced risk management tools: Use stop loss orders and take profit levels to minimise risk.
- Access global markets such as:
- Commodity CFDs
- Bond CFDs
How to Start CFD Trading Today
Step 1: Your Trading Platform
Picking the right trading platform is one of the first things to consider when trading. Finding the best options trading platform can be a bit tricky, as not all offer the variety of markets traders need in today's globalised marketplace. While having access to global markets is important, other factors such as stability, user-friendliness and accessibility are also important. With CFD trading you can start trading on the most used and well-known trading platforms in the world such as:
- MetaTrader Supreme Edition plugin (exclusive to Admiral Markets)
Unlike very niche options trading platforms, the MetaTrader platforms are the go-to software for CFD trading worldwide. This means that there is much more support and more features available for individual traders.
Step 2: Your Trading Methodology
CFD trading is a simple form of speculation on the financial markets. However, with so many potential trades available across so many markets - where some even trade 24 hours a day - how can a trader identify the best reward to risk opportunities? By having a methodology that includes:
- Your routine: When will you look at the markets each day?
- Your style: What kind of trader are you? Day trader, scalper, swing trader or will you manage trades more like an longer term investor?
- Your markets: Which markets will you focus on? Shares, Forex, commodities, indices?
- Your methodology: How will you make trading decisions to buy, to sell, or to exit a position at profit or loss?
You may not know the answer to some or any of these questions yet. However, it's important to remember that trading is a practical endeavour, where opening a live account and watching how markets move can help you to understand more about how the markets work. Now you know more about options trading, CFD trading, and how to get started - what will your next trade be?risks.