This is a beginners guide and some of the language is for complete rookies to trading anything, which we are clearly not. However this reconfirms a lot of what you already know and Fotis goes on to explain in a number of videos how the options trading process works. We also have arranged for you to have a demo trading platform (including a live data feed) so you can practise trading options on a demo account:

Many investors have a physical need to trade, i.e., they require the actual delivery of the product they are buying. Airline companies need to buy jet fuel, jewellers need to buy gold, grocery stores need to buy fruits and vegetables, etc.1

Not all investors require the physical delivery of a product.

Instead, they buy a product with the expectation that its value will increase and they will be able to sell it for a profit. These investors are called speculators and they are only interested in the changing price of a product.

A common term used for this type of trading is ‘Contract For Difference’ (CFD), whereby the speculator takes out a contract and their profit or loss depends on the difference between the price they bought at (purchased) and the price at which they close (sold).

It’s the same as buying a house for £100,000 and in 5 years’ time being able to sell it for £150,000, the difference and profit are £50,000.

Note: This does not involve physically buying or selling products, but merely booking trades to profit from price increases and decreases.

Using online trading, you can even sell a product you don’t own! ‘How do I sell a product that I don’t own’, I hear you ask! You can use your investment (in your own currency) as a deposit to sell any other product.  If you sold a product and its price fell, you would profit.

Let’s consider the house example again, imagine you sold a house for £200,000, and a year later, you were able to buy it back for £100,000, the difference and your profit is £100,000.  In this situation, you receive a higher amount than you have to pay back. It is the same when you sell on a trading platform. For example, if you hold a trading account in euros, you can place a deposit in euros to facilitate a trade to sell Crude oil. The trading platform calculates the deposit you must put down based on the amount of oil you want to sell.

You can speculate on almost any financial product in the world. If you expect the price of the product to increase, you would buy it, and if you expect the price of the product to decrease, you would sell it. The next sections of this lesson cover a few more things you need to know before you learn about options themselves.

Leverage

Have you ever wondered why or how deal sizes are so big in financial market transactions? That is because to make a profit from small moves in the market, you need to trade larger deal sizes. But if you don’t have $100,000 or more, how do you start trading? You use leverage.

Leverage is the practice of putting a small amount of money down (as a deposit) to trade a bigger amount. For example, you could put down $1000 to trade a $100,000 deal and the smaller amount is called the margin. You may have heard of ‘margin trading’, which is the ratio between the smaller and larger amounts of leverage. For example, if you use a $1000 deposit to trade a deal size of $100,000, it is 1:100 leverage; that is $1000 fits 100 times into $100,000.

You don’t actually need the full deal size to be able to trade it, you only need to cover the risk. Leverage allows you to take advantage of small moves in the market and to increase your investment return. Incidentally, your risk also increases. Short-term traders sometimes only hold a trade for a few minutes! However, the duration of your trade will entirely depend on your market outlook.

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Liquidity

Liquidity is a statement of how much a specific product is traded. A frequently traded product is said to be liquid, meaning there are plenty of buyers and sellers available in the market making it easier to find prices at which to trade. A product with a smaller number of buyers and sellers, thus less traded, is known as illiquid. The price of illiquid products is more likely to fluctuate as there isn’t enough ‘flow’ in the market to support smooth pricing.

How does liquidity effect you?

Products which are more ‘liquid’ tend to come with smaller spreads, i.e., they have smaller charges to trade. This is because the high turnover of trading in these products make it possible for banks and brokers to lower costs. For example, Euro against US dollar (EUR/USD) is the most traded currency pair in the world and comes with the tightest spread whereas the US Dollar versus the South African Rand (USD/ZAR) is less liquid, therefore it has a higher spread.

Controlling maximum risk

When using leverage to buy or sell, you may be exposed to a large risk (and you may also be exposed to a large profit). To control your total risk, you can use a stop-loss order. This order automatically closes your trade at a certain price on reaching a certain amount of loss. When the trade is closed, you are not exposed to losing more money. For example, you buy gold at $1200 per ounce because you expect the price to rise and, at the same time, place a stop-loss order at $1100. If gold price subsequently falls, your trade will be closed at $1100 and your loss is limited from that point. It is your decision to determine how wise it is regarding managing your risk for every trade you place.

Below, is another example, let’s say you buy EUR/USD at 1.3300 because you expect the price to rise. This is indicated by the red dotted lines on the chart. At the same time, you protect your maximum loss if the price were to fall by placing a stop-loss order at 1.3200. On day 15, the market suddenly falls and by day 18, the price of EUR/USD passes your stop-loss at 1.3200. This is indicated by the green dotted lines on the chart. Your stop-loss automatically closes your trade preventing further loss to your account’s balance as the market falls below 1.3200.

Capturing profit

A take-profit order closes a trade at a certain price level to lock-in profit. You decide where to place the take-profit order depending on your target price. For example, you buy EUR/USD at 1.3300 and if you expect it to rise to 1.3400, you can place a take-profit order to automatically close the trade at 1.3400 and lock-in profit at this point. You cannot make more money once the trade is closed and the final profit is credited to your trading account. This example is demonstrated in the chart below. After buying at 1.3300 on day 8, the price subsequently moved up in your favour. On day 14, it reached the take-profit order, which automatically closed the trade and the profit locked-in.

Derivatives

This sounds like a very complicated word only bankers know, but it really isn’t! When we say one thing has derived from another, the exact same meaning applies to financial derivatives. It is a broad way of describing a financial product’s value has come from another financial product’s value.

Futures contracts are a popular derivative which allow investors to pre-determine a price for the future. For example, I could buy gold today at the current market price of $1292. But, if I wanted to set a price in the future, I could buy a June 2015 futures contract for $1298. The June futures contract’s value is derived from the current market’s value. We call the current value of the underlying price and the futures’ value a derivative of the underlying price.

Options are another type of derivative. The value of an option is derived from the value of the underlying market.

Check out the next lesson, ‘Introduction to Options’ to start learning more about options.