Listed options are derivative instruments that give the holder the right to trade an underlying asset at a predetermined price on or before a specific date but do not require them to do so. Investors typically use options as a way to hedge against downside risk or to speculate on the future direction of an underlying asset.

While options can provide investors with a valuable tool for managing risk, they also come with risks. This article will examine key risk elements and trading strategies for listed options.

Options risks

There are two main types of risk when trading options: directional risk and volatility risk. Directional risk is the risk that the underlying asset’s price will go wrong. Volatility risk is the risk that the underlying asset’s price will move more or less than expected.

Directional risk

The most obvious way to lose money when trading options is to buy an option and then see the price of the underlying asset move in the opposite direction, known as directional risk.

There are several ways to manage directional risk, including:

• Only buying options that are “in-the-money” (i.e., where the strike price is below the current market price for call options or above the current market price for put options)
• Using a stop-loss order to limit losses if the price does move against you
• selling the option before expiry if it looks like the price is going to move against you

Volatility risk

Volatility risk is the risk that the underlying asset’s price will move more or less than expected, which can happen even if the price moves in the right direction.

There are several ways to manage volatility risk, including:

• buying options with a longer time to expiry (i.e., “longer-dated” options)
• buying options with a higher strike price (i.e., “out-of-the-money” options)
• using a stop-loss order to limit losses if the price moves more than expected

Common trading strategies

There are several common trading strategies for listed options. These include:

• buying calls to speculate on a rising market
• buying puts to speculate on a falling market
•  writing covered calls to take advantage of a stagnant market
•  writing naked puts to speculate on a rising market
• Use spreads such as a straddle and strangle to speculate on significant market moves or limit losses in a volatile market.

Each of these strategies has different risks and rewards. It is essential to understand these before entering into any options trade.

Buying calls

Buying call options is a bullish strategy that can be used when the trader expects the underlying asset price to rise. The potential reward from this strategy is unlimited, as the underlying asset price can theoretically rise to infinity. The risk is limited to the premium paid for the option minus any dividends paid on the underlying asset.

Buying puts

Buying put options is a bearish strategy that can be used when the trader expects the underlying asset price to fall. The potential reward from this strategy is limited to the premium paid for the option minus any dividends paid on the underlying asset. The risk is unlimited, as the underlying asset price can theoretically fall to zero.

Writing covered calls

Writing covered calls is neutral to a bullish strategy which can be used when the trader expects the market to rise or fall but doesn’t have a strong opinion. The potential reward from this strategy is limited to the premium received for writing the call minus any dividends paid on the underlying asset. The risk is limited to the difference between the call’s strike price and the underlying asset’s current market price minus any premiums received.

Writing naked puts

Writing naked puts is a bullish strategy that can be used when the trader expects the underlying asset price to rise. The potential reward from this strategy is limited to the premium received for writing the put minus any dividends paid on the underlying asset. The risk is unlimited, as the underlying asset price can theoretically fall to zero.

Conclusion

Listed options offer a versatile tool for traders who want to trade options in the UK. They can speculate on the market or hedge their portfolios. Risks come with all options and strategies, therefore it is essential to understand them before entering any trade.