Financial markets have been particularly volatile in the opening months of 2020, with fluctuations propelled by an ever-changing international trading landscape.
Once global trade returns to relative normality, there will still be the unresolved issues of the US-China trade war and the UK-EU Brexit negotiations shaping the value of stocks and currencies.
The unpredictability of markets could mean that short-term investments are ill-advised throughout the bulk of 2020, so traders may be considering their options – literally. Options trading gives investors the chance to speculate on a future market value with no obligation to complete the trade, thereby safeguarding traders against dramatic short-term fluctuations.
There are two fundamental features of option trading: call options and put options. A call option gives the owner the opportunity to buy an underlying market at a preset price (known as the strike) within a pre-determined time period. If the value exceeds the strike, the trader makes a profit on their option.
A put option operates in a similar manner but with selling rather than buying. If the market falls below the strike price, the option generates a profit. There is no requirement to buy or sell at any given moment, with that flexibility particularly attractive at a time of high market volatility.
Investors also have the possibility of selling their entire option in the aim of covering their premium, the expenditure with which they acquired the option. Traders can choose between European and American options, depending on availability and their preferred style of investing.
European options
All options have an expiration date after which the trader loses their power to buy or sell. The owner of a European option can only execute their right on a call or put when their option reaches maturity, which occurs on the third Friday in the month of expiry. European options cease trading at the close of play on the Thursday before, then brokers analyse market shifts and price up the option for traders on the Friday.
American options
The owner of an American option can execute their right to buy or sell at any point within a pre-determined time period. This allows traders to react to short-term market shifts that take their option above or below the strike price. However, investors can also leave the option until its expiration date, often the third Friday of the month.
The key differences
The most notable difference between European and American options is the flexibility in terms of buying and selling. The American version allows investors to execute their trade once markets reach a favourable threshold for their call or put option, which is not a feature of the European equivalent. However, European options generally come at a lower premium, so there is pressure on American options to generate a greater profit as compensation for their higher initial cost.
The flexibility of American options places more emphasis on strategy, as exercising the right to buy or sell before the expiration date runs the risk of missing out on maximum profit that could be achieved if the option was left to maturity. European option traders are not without choices, as they can resell the option before the expiration date if market conditions mean that they will make a profit on their premium.
If you prefer a hands-on approach and have sufficient analytical experience to capitalise on fluctuations, then the freedom to exercise options early makes the American version more suitable. European options are more appealing to those who wish to commit to long-term speculations and are keen to minimise the premium. While both types have advantages and disadvantages, the overall long-term nature of options trading is well-suited to current market instability.
