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Confused with Options


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Hi

I have been experimenting with options trading on my demo account and am struggling to make sense and align the position numbers and the way options trading works on IG with the theory of trading options.

For example I have tested a vertical bullish spread and purchased a Long call on Oil at 4240 (current price was 4260).  I then purchased a short call on Oil at 4280.  Therefore I think my long call is in the money and my short call is out of the money.

My balance has reduced by roughly £100 due to a £40 margin on the long call and a £60 margin on the short call. IG states that margin and premium are interchangeable so does the £40 for my long call represent the premium I have paid? If so then why have I paid £60 for the short call when as the writer I should receive a premium?

I  am confused as to what Premium I have actually paid for the long call and what premium I would receive for the short call?

As I’ve done a vertical spread I believe that a rising price will eventually provide profit (albeit offset by the short call) but a lowering price would lead to a loss (limited to the long premium minus the short premium I receive).

Is anyone able to provide an IG spread bet example based on a vertical spread hi lighting how I can work out the premiums before I actually place a trade.

 

thanks

Justin

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To add some more detail I opened two test trades today based on the following.

Oil daily expiry @ starting price of 4258

Short call @4300 - option cost was 8.9 @ £1, spread of 5 resulting in £8.90 Margin and starting position of £-5.

Short call @4220 - option cost was 45 @ £1, spread of 4.4 resulting in £45.90 margin and starting position of £-4.40.

Questions:  I thought a short call was essentially bearish - based on traditional options I would receive a premium and hope that the underlying asset price remains static or falls.  For some reason an increase in the underlying asset price is what resulted in the option call sell price and therefore one of my positions turning into profit, and so i am totally confused as to how profit/loss works once my positions are open.

Also the short call @ 4220 was making more profit in relative to the short call @ 4300.   Is there a formula or basic method someone can provide which allows me to understand how the underlying asset price etc is actually going to influence the different call options available?

 

 

 

 

 

 

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Your theory on paying/receiving premium is right. However, when you spreadbet this is not how it works.

The long call option is working as expected, you paid a premium equivalent to the option price. However when you sell an option, the margin is not related to the price paid. For example, the margin to short a FTSE100 call @ 5000 is £350. The price of the call is £1115.

Basically, don't confuse margin and PnL. Margin is what is required to keep the position open, to protect IG from your credit risk (i.e. you walk away without paying). The PnL on the above trade if it expires out-the-money would be +£1115.

As for price changes, you want to look at the delta of the option. Look this up, make sure you understand it. There are online calculators to do the maths for you.

Lastly, most options traders do not trade price, they trade volatility. To be clear, they are not explicitly taking a view on price, they are taking a view on the shape of the volatility surface.

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Thanks.  I found some good articles last night that describe the black  Scholes formula etc and the Greeks.

I had thought the premium was a fixed one off payment Incurred when the position was opened, but if I understand correctly, I am essentially spread betting on the points movement of the Options premium which itself is impacted by a number of factors including price of the underlying asset, Strike price, volatility, time to expire etc.

 

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This is how option writers work out options - if interested

 

One of the easiest and most useful formulas is the following:


Price Change = Current Price x Historical Volatility x Square Root of days left to
expiration all divided by Square Root of the number of trading days in a year.
Trading days in a year is used as a constant number (252). The Square Root of this is 15.875.
Historical Volatility = (52-week high - 52 week Low) / (52-week high + 52-week low)/2
Lets take a hypothetical stock XYZ. We look at the chart over the past year (52-weeks) and find the highest high and the lowest low within this time period. Don't go back further than 1 year. Lets assume that XYZ had a 52-week high of $125 and a 52-week low of $83. This gives us a historical volatility of: (125 - 83) / (125 + 83)/2 or simply (42) / (104), which = 0.404 for historical volatility.


Now, lets assume that the current price of XYZ = $90 and we are looking at options that will all expire in the next 30-days. We just plug these numbers into the Price Change formula and get:
Price Change = $90 x 0.404 x Sqrt(30) / 15.875. Calculating the square root of 30, this gives us ($90 x 0.404 x 5.48) / 15.875 = 12.55 for our price change calculation. This means that there is approximately a 70% chance that the market (XYZ in this example) will stay within +/- $12.55 of its current price. This means that the 102.5 (90 +12.55) Call options and the 77.50 (90 -12.55) Put options have a 70% chance of being worthless by expiration. The greater the price move from this price change of 12.55, the greater the odds are that the option will expire completely worthless. For example, if you double the 12.55 to 25-dollars, you will increase the probability to 95%. In other words, the $115 Call option (90 +25) and the $65 Put option (90 -25) have a 95% chance of being worthless in the next 30-days (expiration date). If you multiply the Price change by 1.5, you get approximately 80% probabilities Multiplying by 1.75, will give around 87% probabilities.

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