When I buy a call option on the FTSE 100 I don’t buy the index, I buy the call. Too many people confuse the call with the index. A call option tracks the index. If the FTSE 100 rises the call will rise and if the FTSE 100 declines the call will decline.
Like any other instrument the call has a bid/offer spread, for example if I select the 7250 Call (February 2017) it may be quoted as 20 to buy, 17 to sell.
Many spread betting companies offer options on the FTSE 100, instead of buying a traditional option one can bet on the option using a spread betting platform. The advantage of spread betting is that it’s free from capital gain tax.
I would like to buy the 7250 Call (February 2017), this call will expire on 17th February. The price to buy is 20, however because I spread bet, I will place a bet, say £10. What is my profit/loss potential? The FTSE 100 is trading at 7230 on the day I buy the call.
On 17th February the FTSE 100 has rallied to 7300 and the price of the call is now 40, my profit is £200 (40 – 20 x £10).
Had I bought the FTSE 100 instead of the call I would have made a larger profit. So what is the advantage of buying the call? Buying the call is lower risk, basically when buying a call the potential loss is limited. Had the FTSE 100 gone the other way I would have lost far less than if I was holding the FTSE 100.
Suppose the FTSE 100 was trading at 7150 on the 17th February, my loss on the call would be £200 (0 – 20 x £10). As you can see the maximum loss I can incur when buying a call is the price I pay multiplied by the bet. If I buy at 20 and bet £10 and I am wrong, the maximum loss is £200. That is because when buying a call the lowest it can go is zero, it cannot go lower. That is the advantage of buying the call.
Had I bought the FTSE 100 instead of the call my loss would be far larger, in this example my loss on the FTSE 100 would be £800 (7150 – 7230 x £10).
Options enable traders to profit from a move but with limited risk.
One disadvantage: options lose value with time
To understand this concept let’s have a look at an example.
On 23rd January the FTSE 100 closed at 7151. The February 7250 call (expiring on 17th February) closed at 28.
On 9th February the FTSE is trading at 7190 but the 7250 call is now trading at 6. So the FTSE 100 has gone up slightly while the 7250 call has gone down massively. Why has the call not gone up with the FTSE as expected? The reason is because time is running out, the call will expire in 8 days and because calls lose value each day, the nearer to the expiry date the faster they lose value. The gain from the rising FTSE 100 has been wiped out by the loss of value due to time. This is the main disadvantage, if you buy a call and the FTSE 100 takes too long to rally, you may not make a profit on the call.
You can also take advantage of this depreciation due to time, if you are short. If you sell a call, time is on your side. For example if the FTSE 100 goes sideways the call will lose value with time and your short position will make money. Say you believed on 23rd January that the FTSE 100 would rally but at the same time upside was limited (for example because the index was near overbought). You could have sold the 7250 Call (February). This trade would only make a profit if the FTSE 100 does not rally too high. In this situation the potential loss is unlimited, as long as the FTSE 100 rises the call will rise. This is more risky than buying a call and you need to have a stop loss in place to avoid excessive losses. But the advantage of selling calls is clear, as long as the FTSE 100 does not rise too high or goes sideways or goes down the trade will make money.