In the UK, options trading is a well-established market that is home to a large number of different types of listed options. Options are trendy because they allow retail traders to access a dynamic and flexible market, which can generate good profits quickly.
However, investors need to be aware that particular risks are associated with this type of investment activity. Compared with other forms of options trading such as Exchange Traded Options (ETOs) or American Style Options, Listed Options can carry risks that make them unsuitable for many types of investors.
Traders like listed options because they can be traded on major exchanges and settled in cash. They also offer traders access to some markets that would otherwise be difficult to invest indirectly. But while these contracts may settle in cash, they still require margin lending. If the value of the contract moves against you, it could result in significant losses, even before the settlement date arrives. Therefore, listed options come with some additional risks that aren’t associated with other types of investment products.
Counterparty default risk
The main risk is counterparty default or credit risk, as traders and brokers more commonly refer to it. This refers to the possibility that the party on the other side of your trade will default before settlement. In some markets, it can be difficult to judge where you may not have much experience or reliable information about the counterparty’s creditworthiness. It means it is essential to do thorough research when deciding what listed options you will invest in and where you will open an account with a broker.
Rate of maturity
Another risk relates to how quickly listed options can mature relative to different underlying assets. Many traders like options because time decay speeds up as expiration nears. It also means that if an asset moves sharply against you before you have enough time for your position to work itself out, then your losses could increase significantly. Therefore, traders should carefully consider how long they are willing to risk their capital when opening a position.
ETOs (exchange-traded option) in the UK have a minimum expiry time of 11 days. It means that to have a chance to profit, investors must hold the position open for at least this length of time, which is not always practical or possible. By contrast, Listed Options have no expiry dates, meaning they can be held indefinitely, so long as the call option remains profitable.
As a result, inexperienced investors looking for rapid gains are much more likely to suffer losses when trading listed options because they leave their positions open at all times to extract value from them.
Gearing and leveraging effects
Another significant risk associated with UK listed options trading is gearing/leveraging effects. For example, by using £1 of free margin capital and borrowing £99 against it (assuming 100 :1 gearing), an options trader can control a £100 position.
For example, if the underlying asset’s price were to rise by five per cent (from 100p to 105p), then the position’s value would increase by 500% (50p – 55p). However, as leverage increases profits and losses on investment, these types of geared positions are more prone to market volatility and fluctuations to generate any return.
For UK traders, there are other risks to consider as well. For example, recent changes in the taxation of UK investors have seen the abolition of personal allowances on dividend income for higher rate taxpayers and increased stamp duty charges on stock market transactions. It means that while listed options may be an attractive investment product, they come with some out-of-pocket costs, which can significantly reduce your overall return. These make it increasingly worthwhile to carefully consider all the pros and cons before taking the plunge into this alternative form of investment and using a reputable online broker from Saxo Bank.