As one of the oldest financial markets, the UK options market has come a long way over the years. However, even in its advanced state, traders still experience difficulties when trading. These include high costs, low liquidity and unsuitable risk controls, to mention a few.
Regarding costs, options are pretty expensive compared to other products due to lower levels of liquidity. The cost associated with this is twofold. Firstly there are brokerage commissions which can be as high as £10/trade for large portfolios. Secondly comes the bid-offer spread. This is an essential difference between what price you can sell your option for (the bid) and what price you would repurchase it at (the offer). This spread is typically between 10-20%, although the price falls significantly during low liquidity periods.
The bid-offer spread will be much less if you are prepared to trade UK options with a smaller portfolio. You can also look for certain brokers who have low commissions. For example, TD Direct Investing offers trades at a £6 flat rate. It is important to note that this £6 fee does not apply to all strategies or worldwide stocks, but it means that traders are likely to keep more profits when trading options.
It goes without saying that if you can make your trades cheaper and use risk controls properly, you will increase the size of your positions. It’s vital, though, that options traders know exactly what they are doing before increasing their positions.
Implementing a short strangle strategy would be another way to decrease the bid-offer spread in a low volatility situation. A long call and put with closer strikes is another way to reduce the cost of options trading, although this doesn’t always produce results. However, it increases time decay during low volatility periods. This means that you get less ‘moneyness’ for your option, so it has less value. It is important to note that time decay is usually highest on out-of-the-money options, so they will lose most of their value during these periods.
As experienced traders will know, it is vital to have a solid understanding of the trading platform being used. This means knowing how order types work and having a good general knowledge of your graphs and charts. Inexperienced traders may not realize that they can reduce commissions by using certain price increments or specific order types such as “Fill or Kill”. This will help you avoid getting trapped into sending out orders with low liquidity when prices move against you before the trades are closed.
So far, this article has focused on low volatility situations. However, a high volatility situation works very much in an options trader’s favour. Here, the bid-offer spread reduces, and time decay becomes more favourable. It is crucial to recognize high and low volatility markets which can be difficult when new to trading. It requires a good level of experience and knowledge about current market trends, news releases and major announcements.
Limit orders are helpful for those traders who want to control exactly where their order will be traded. This is important because it allows you to manage your risk within the market and avoid having a position filled outside acceptable limits.
Beyond this, it must be noted that the bid-offer spread increases during times of high volatility, so limit orders can help an options trader close a profitable trade at a reasonable price. The opposite is true when there is low volatility or illiquidity in the option, which means traders should use limit orders with caution if they don’t wish to have positions closed prematurely.
Trading UK Options isn’t as difficult as some people think, but it does require due diligence from the trader. You must remember that no strategy will be fool-proof, and there will always be downsides. If you are prepared, however, you can certainly decrease your risk exposure and increase the size of your portfolio over time.