If you are a beginner in options trading, it is essential first to understand what options are and how they work before delving into the more complex world of algorithmic trading. In its simplest form, an option is a contract between two parties that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a certain period.
While options can be traded on many different types of underlying assets, including stocks, currencies, commodities and even cryptocurrencies, in this guide, we will focus on options that are traded on the stock market.
Call options and put options.
There are two main types of options – call options and put options. A call option gives the holder the right to buy the underlying asset at a predetermined price, while a put option gives the holder the right to sell the underlying asset at a predetermined price.
Strike price and the expiration date
When trading options, there are two main things you need to know – the strike price and the expiration date. The strike price is when the underlying asset can be bought or sold if the option is exercised. The expiration date is when the option expires and can no longer be exercised.
American and European options contracts
There are also two main types of options contracts – American and European. An American options contract can be exercised before it expires, while a European options contract can only be exercised on the expiration date.
Now that we have a basic understanding of what options are let’s look at how they are traded.
Two ways you can trade options
Broker
Brokers offer various options for products that you can trade, including both calls and puts. The advantage of using a broker is that they offer a lot of education and support, especially helpful for beginners. Brokers also tend to have lower commissions than exchanges. You can find a Singapore based and regulated options broker that offers educational articles and tools here https://www.home.saxo/en-sg/products/listed-options.
Exchanges
On the other hand, Exchanges offer a much more comprehensive range of products to trade, including more complex option strategies such as spreads and straddles. However, exchanges typically have higher commissions than brokers, and they also don’t offer much in terms of education and support.
How can options be traded using algorithms?
Algorithmic trading is often used by institutional investors such as hedge funds and large banks, but it is also available to retail traders through online brokerages.
One advantage of algorithmic trading is that it can help you remove emotion from your trading. When manually placing trades, it can be easy to let emotions like fear and greed influence your decisions. However, when you are using an algorithm, your trade decisions are based purely on the conditions you have set up in your program.
Now that we know a bit about algorithmic trading let’s look at some of the most popular algorithms that can be used.
Trend Following
One of the most popular algorithms is a trend following. Trend followers use technical indicators like moving averages or MACD to identify trends in the market and then trade accordingly.
Arbitrage
Another popular algorithm is arbitrage. Arbitrageurs take advantage of price differences between different markets to make a profit. For example, if the price of Gold is $1,200 on one exchange but $1,250 on another, the arbitrageur could buy Gold on the first exchange and then sell it immediately on the second exchange for a profit.
Statistical Arbitrage
Statistical arbitrage is a type of algorithm that looks for mismatches in pricing between different markets. For example, if two stocks have a high correlation but one is trading at a higher price than the other, the statistic arbitrageur will take a position in both stocks to capture the discrepancy.
Options Arbitrage
Options arbitrage is another popular algorithm that takes advantage of differences in options prices between different exchanges. For example, if the price of an option on one exchange is $10 but $15 on another, the options arbitrageur will buy the option on the first exchange and then sell it on the second exchange for a profit.