How to trade options

In this article I explain how call options work. There are two types of options, calls and puts, this article is about call options on the FTSE 100.

Call options have a bid-offer price like any other instrument and they have an expiry date. The important thing with options is that the value of the call option decreases with time. For example if a call option goes sideways from now to the expiry date the value will drop to zero. Therefore to make money with call options we need the market to move up or down before the option expires and fast.

I would say 95% of my option trades are in calls, I seldom trade puts. Let’s focus on call options.

A call option rises and falls with the FTSE 100 so If the FTSE 100 goes up the call option will go up. There are two scenarios: I expect the FTSE 100 to rally so I buy a call option, or I expect the FTSE 100 to decline so I sell a call option. Why would I trade the call instead of the index?

  • I expect the FTSE 100 to rally so I buy a call option

I buy a call option instead of the index when I think it’s too risky to buy the index. For example in a bear market you want to capitalise on the counter trend rallies but there is a risk, the index could collapse. Buying a call option is safer than buying the index because the maximum loss is limited to the price you pay. So you benefit from the upside but your loss is limited.

Example: the 6400 call (June) is 22 to buy and 17 to sell. If I buy at 22 and I bet £5 my maximum loss is £110 (5 x 22). I can’t lose more than that because if the FTSE 100 does not rally by the time the call option expires in June, the call option will drop to zero. It can’t go lower than zero. If however the FTSE 100 rallies my call option will rise and I will make money.

As the loss is limited there is no need to have a stop loss. When buying a call option I don’t use a stop loss.

  • I expect the FTSE 100 to decline so I sell a call option

I sell a call option instead of the index when I think the FTSE 100 will decline or go sideways. When I am short a call option time is on my side. Each day that passes the call option drops in value and because I am short I make money. If the FTSE declines the call option will drop to zero and if the FTSE goes sideways the call option will also drop to zero.

I will sell call options when I believe the FTSE is near a top, when upside is limited the index will take longer to rally further. It may pullback and rally again but by the time the index is higher the call option will have lost more value. Therefore we could be in a situation where the FTSE rallies yet the short on the call options make money. That can happen if the FTSE takes a long time to rally, which is one advantage of shorting call options.

What is the risk? unlike buying a call , selling a call option carries a high risk because in theory the more the FTSE rises the more the call increases in value so my potential loss is illimited. That is the drawback of selling call options, if the FTSE rallies strongly the loss will become large and in that situation I will need to take action to protect my fund. I protect (hedge) my short calls either by buying another call option or buying the FTSE 100. The more common hedge is to buy the FTSE 100.

Because call options and the FTSE don’t move at the same pace I need to bet more on the call option (assuming I have 1 call option and 1 FTSE 100). For example if the FTSE 100 rallies 100 pts, the call option may rally 25 pts. Say I am short £10 on the call option and the FTSE 100 rallies 100 pts, my loss on the call option would be £250 (25 x 10). It’s like saying I was short £2.5 on the FTSE 100 (2.5 x 100). As you can see in this example the ratio is 1 to 4. To neutralise my short on the call option I need to go long four time less on the FTSE 100. In general the ratio is between 3 and 4, if I am short £8 on the call option I need to go long £2 or £3 on the FTSE 100 to hedge.

What about if I have different call options?

In this case I bet the same amount on each call option. For example if I am long £10 on the FTSE 100 I will go short the same amount on each call option. Say I have the following call options:

Short 6300 Call (June), size £10

Short 6325 Call (June), size £10

Short 6350 Call (June), size £10

If the FTSE rallies and I wanted to hedge I would buy FTSE 100 for £10. This would not be a perfect hedge but it would reduce my short exposure to a negligible level. As you can see the amount to bet on the FTSE is the same as those on the call options.

How to place an option trade on your trading platform

We are looking for the 6350 Call (June)

IG index: select Options (FTSE) – select JUN – Select 6251-6500 – select FTSE 6350 CALL

City Index: select Options – select Options UK 100 – select June – select UK 100 Jun 16 Call 6350 spread