GET Financial Education Series - Forex
Forex Options – Lesson 9
You need at least Flash Player 7 to view this website.
Please go to:
http://www.adobe.com
to download the latest version.
Forex options are the next frontier in forex trading. Forex options give
you just what their name suggests: options in your forex trading. If you
have been looking for a way to add unparalleled flexibility to your trading,
you have come to right place. GET Financial has the most comprehensive forex
option trading platform in the industry. Come see what you have been missing
by simply buying and selling currency pairs.
Forex options allow you to not only take advantage of movement in a currency
pair but also limit the risk you expose your account to. You can make money
with options when currency pairs are moving higher, when currency pairs
are moving lower and even when currency pairs are moving sideways.
We will begin with standard options in this section to lay a solid foundation
to get you started in your option trading. Standard options are also called
vanilla options because they are plain and simple - they don't have a lot
of extra frills. In subsequent sections, we will discuss exotic options
- options with extra frills that you can apply in unique situations.
In this options section, we will explain the following to get you ready
to place your first option trade:
- What vanilla options you can trade - calls and puts
- What affects option values - option Greeks
- What type of option trader you will be - buyer or seller
Vanilla Options - Calls and Puts
Vanilla options come in two varieties: calls and puts. Call options give
you the right, but not the obligation, to buy a currency pair at a certain
price on or before a certain date. Put options give you the right, but not
the obligation, to sell a currency pair at a certain price on or before
a certain date.
You have the ability to both buy and sell call and put options. If you
believe a currency pair is going to move higher, you can either buy a call
option or sell a put option to take advantage of the upward movement of
the currency pair. If you believe a currency pair is going to move lower,
you can either buy a put option or sell a call option to take advantage
of the downward movement of the currency pair.
You will learn more about what you can do with options later in this section
when we discuss what type of an option trader you will be. Right now it
is important for you to learn the basics of what options are and how they
work so you can use them appropriately in your forex trading. Take a moment
to become familiar with the following:
- Unique characteristics of forex options
- Value of a forex option
Option Characteristics
Forex options are unique, multi-dimensional trading tools. They give
you tremendous flexibility in your investing. If you want to successfully
use them in your own portfolio, however, you need to become familiar with
their distinctive traits.
Every vanilla option has the following three characteristics:
Strike price: this is the price at which you can buy
a currency pair (if you have bought a call option or sold a put option)
or you can sell a currency pair (if you have bought a put option or sold
a call option).
Expiry date: this is the date on which the option expires,
or becomes worthless, if nobody exercises it.
Premium: this is the price you pay when you buy an option
and the price you receive when you sell an option.
For example, you can buy a call option on the EUR/USD with a strike price
of 1.4000 and an expiry date of December 21 by paying a premium of $1,800.
By doing so, you have paid $1,800 for the right to buy the EUR/USD currency
pair at 1.4000 on December 21.
The Value of an Option
The value of an option has two elements: intrinsic value and time value.
Intrinsic value - Market convention is to refer to the price of the underlying
asset minus the strike of the option as the option's intrinsic value (for
a Call option, for a Put it is just the opposite). Theoretically, one
could argue that the forward rate of the underlying asset should be used
instead of its spot, but market convention is to use the spot.
Time value - Simply put, an option's time value is the amount by which
the value of the option exceeds the intrinsic value. The volatility of
the underlying asset has a significant bearing on the time value. Time
value increases as volatility increases because of the Profit/Loss scenario
for an option. As previously mentioned, the potential upside for an option
holder is unlimited, while the downside is limited to the premium paid.
Hence, an option on an asset which is more likely to take on extreme values
is much more valuable than on a less volatile asset.
Interest rates differentials in the two currencies involved in a currency
option trade must also be taken into consideration when pricing an option,
and these are also a function of time.
This graph depicts how a call option is priced according to how close
the asset price is to the strike price for the option.
Let's say that you hold a Call option with a 1.2000 strike price, and
that the market price of EUR/USD has risen to 1.2155. Your option is worth
225 pips thirty days before the option's expiration date. The intrinsic
value is the difference between the strike price for the underlying asset
in the option contract (1.2000) and the market price (1.2155). If you
hold a call option, which gives you the right to buy EUR/USD at 1.2000
and the market price is 1.2155 the intrinsic value of the option is 155
pips. So the price of the option is the intrinsic value plus the time
value (in this case 70 pips).
Option Greeks
Option prices are affected by five factors, each of which has a Greek
name to represent it. As you progress as a forex option trader, you will
see the following options Greeks on a regular basis:
- Delta
- Gamma
- Theta
- Vega
- Rho
Delta - Describes how the value of an option changes
as a result of small changes in the underlying asset, assuming that all
the other factors influencing option pricing are constant. The delta of
an option can also be viewed as the required hedge for the option against
changes in the underlying spot, i.e. the position in the spot which ensures
that the Profit/Loss on the option is offset by the Profit/Loss on the
spot position. For each options position, the table below indicates the
direction, i.e. whether to buy or sell, of the hedge position in the spot.
Gamma - Describes how the delta of the option changes
when the underlying asset changes. Hence, the gamma also describes how
you should change your hedge to remain delta neutral when the spot moves.
All purchased standard options, calls and puts, have positive gamma.
The gamma position also provides insight into the investor's view on
the volatility of the underlying asset, as a long position shows expectations
of a volatile market while a short position indicates that he/she expects
a calm market.
Theta - Describes the change in the value of the option
when time passes and everything else remains constant. This change stems
from the fact that the time to an option's expiration is reduced with
the passage of time. This change in value is also commonly referred to
as how much the option 'bleeds' the speculator. The theta (sensitivity)
is often noted in pips lost in value per day that passes.
Vega - Describes the change in the value of the option
when the volatility changes. The volatility represents how large the swings
are in the underlying asset and is the cornerstone in option pricing.
Larger swings imply that the underlying asset is more likely to take on
more extreme values. While the option holder's risk is limited to the
premium, his/her upside is unlimited for vanilla options. Hence, an increase
in the volatility of the underlying asset increases the value of the option.
As the table below suggests, the sensitivity is larger the closer to At-The
Money (ATM)* the option is and the longer it has until it expires.
Rho - Describes the sensitivity of the option price,
based on the Black-Scholes model, with regards to changes in the interest
rate. Hence, the Rho does not include the impact that a change in the
interest rate has on the exchange rate. For foreign exchange options,
their values depend on both the interest rate on the base currency (which
is the euro for the EUR/USD) and the interest rate on the reference currency
(which is the dollar for the EUR/USD).
*At-the-money means that the strike price is the same as the current
price of the currency pair when you enter the trade.
Option Buyers and Option Sellers
Forex option traders can be either option buyers or option sellers. Option
buyers are those traders who enter a trade by buying either a call or a
put option. Option sellers are those traders who enter a trade by selling
either a call or a put option. Your decision to buy an option contract or
to sell an option contract will be based on whether you are bullish or bearish
on a currency pair.
You can make money with forex options whether currency pairs are going
up, down or sideways.
Up - If your fundamental and technical analysis tells you that the currency
pair is going to be moving up, you can either buy a call option or sell
a put option.
Down - If your fundamental and technical analysis tells you that the currency
pair is going to be moving down, you can either buy a put option or sell
a call option.
Sideways - If your fundamental and technical analysis tells you that the
currency pair is going to be moving sideways, you can either sell a call
option or sell a put option.
| |
CALL |
PUT |
| UP |
BUY |
SELL |
| DOWN |
SELL |
BUY |
| SIDEWAYS |
SELL |
SELL |
Buying a call or a put option allows you to take advantage of virtually
unlimited profits so long as the currency pair continues moving higher if
you bought a call option or lower if you bought a put option. However, the
currency pair does have to move far enough to overcome the initial premium
you paid for the option.
Selling a call or a put option allows you to collect your profits up front
and keep the full profit so long as the currency pair remains below the
strike price of the call you have sold or above the strike price of the
put you have sold. However, if the currency pair does move past your strike
price, you can lose more money that you collected by selling the option.
- Buying a call option
- Buying a put option
- Selling a call option
- Selling a put option
Before you look at how these option trades will react, however, you need
to acquaint yourself with the tool we will be using to illustrate the affect
various market conditions will have on your option trades: a risk graph.
Let's take a look at how each of the following option trades reacts in
various market conditions (assuming you buy or sell ATM options):
Buying a Call Option
Buying a call option, or going long the call option, is a bullish option
trade - which means you want the underlying currency pair to go up in
value. If the currency pair goes up, you will maximize your profits on
your call trade.
Unfortunately currency pairs don't always do what you want them to do
in the forex market, and you need to know what will happen to your call
option in various scenarios. A currency pair can do one of the following
five things:
- Go up a lot
- Go up a little
- Remain flat
- Go down a little
- Go down a lot
Up a Lot - When you have bought a call and the currency
pair moves up a lot, you maximize your profits on the trade. Every pip
higher the currency pair moves above the breakeven point for the call
option makes you more money. You can see how the blue profit/loss line
continues to rise after it crosses the breakeven point.
Up a Little
- When you have bought a call and the currency pair moves up a little,
you minimize your losses on the trade. Every pip higher the currency pair
moves above the strike price for the call option reduces your losses.
You can see how the blue profit/loss line starts to rise after it crosses
the strike price level but that it is still below breakeven.
Flat -
When you have bought a call and the currency pair remains flat, you reach
the maximum loss on the trade. When you buy a call option, you must pay
the premium up front. If the currency pair remains flat, you lose the
entire premium (your maximum loss). You can see how the blue profit/loss
line reaches its lowest level at the strike price.
Down a little
- When you have bought a call and the currency pair goes down a little,
you reach the maximum loss on the trade. When you buy a call option, you
must pay the premium up front. If the currency pair goes down a little,
you lose the entire premium (your maximum loss). You can see how the blue
profit/loss line remains flat at its lowest level below the strike price.
Down a lot
- When you have bought a call and the currency pair goes down a lot, you
reach the maximum loss on the trade. When you buy a call option, you must
pay the premium up front. If the currency pair goes down a lot, you lose
the entire premium (your maximum loss). You can see how the blue profit/loss
line remains flat at its lowest level below the strike price.
In review, here are the results you can expect from different price action
when you buy a call option.
| PRICE
ACTION |
RESULT |
| Up a Lot |
Maximize Gains |
| Up a Little |
Minimize Losses |
| Flat |
Achieve Maximum Loss |
| Down a Little |
Achieve Maximum Loss |
| Down a Lot |
Achieve Maximum Loss |
Buying a Put Option
Buying a put option, or going long the put option, is a bearish option
trade - which means you want the underlying currency pair to go down in
value. If the currency pair goes down, you will maximize your profits
on your put trade.
Unfortunately currency pairs don't always do what you want them to do
in the forex market, and you need to know what will happen to your put
option in various scenarios. A currency pair can do one of the following
five things:
- Go up a lot
- Go up a little
- Remain flat
- Go down a little
- Go down a lot
Up a Lot
- When you have bought a put and the currency pair moves up a lot, you
reach the maximum loss on the trade. When you buy a put option, you must
pay the premium up front. If the currency pair goes up a lot, you lose
the entire premium (your maximum loss). You can see how the blue profit/loss
line remains flat at its lowest level above the strike price.
Up a Little
- When you have bought a put and the currency pair moves up a little,
you reach the maximum loss on the trade. When you buy a put option, you
must pay the premium up front. If the currency pair goes up a little,
you lose the entire premium (your maximum loss). You can see how the blue
profit/loss line remains flat at its lowest level below the strike price.
Flat -
When you have bought a put and the currency pair remains flat, you reach
the maximum loss on the trade. When you buy a put option, you must pay
the premium up front. If the currency pair remains flat, you lose the
entire premium (your maximum loss). You can see how the blue profit/loss
line reaches its lowest level at the strike price.
Down a little
- When you have bought a put and the currency pair goes down a little,
you minimize your losses on the trade. Every pip lower the currency pair
moves below the strike price for the put option reduces your losses. You
can see how the blue profit/loss line starts to rise after it crosses
below the strike price level but that it is still below breakeven.
Down a lot
- When you have bought a put and the currency pair goes down a lot, you
maximize your profits on the trade. Every pip lower the currency pair
moves below the breakeven point for the put option makes you more money.
You can see how the blue profit/loss line continues to rise after it crosses
below the breakeven point.
In review, here are the results you can expect from different price action
when you buy a put option.
| PRICE
ACTION |
RESULT |
| Up a Lot |
Achieve Maximum Loss |
| Up a Little |
Achieve Maximum Loss |
| Flat |
Achieve Maximum Loss |
| Down a Little |
Minimize Losses |
| Down a Lot |
Maximize Gains |
Selling a Call Option
Selling a call option, or going short the call option, is a bearish option
trade - which means you want the underlying currency pair to go down in
value. If the currency pair goes down, you will maximize your profits
on your call trade.
Unfortunately currency pairs don't always do what you want them to do
in the forex market, and you need to know what will happen to your call
option in various scenarios. A currency pair can do one of the following
five things:
- Go up a lot
- Go up a little
- Remain flat
- Go down a little
- Go down a lot
Up a Lot
- When you have sold a call and the currency pair moves up a lot, you
maximize your losses on the trade. Every pip higher the currency pair
moves above the breakeven point for the call option costs you more money.
You can see how the blue profit/loss line continues to fall after it crosses
the breakeven point.
Up a Little
- When you have sold a call and the currency pair moves up a little, you
minimize your gains on the trade. Every pip higher the currency pair moves
above the strike price for the call option reduces your gains. You can
see how the blue profit/loss line starts to fall after it crosses the
strike price level but that it is still above breakeven.
Flat -
When you have sold a call and the currency pair remains flat, you reach
the maximum gain on the trade. When you sell a call option, you receive
the premium up front. If the currency pair remains flat, you get to keep
the entire premium (your maximum gain). You can see how the blue profit/loss
line reaches its highest level at the strike price.
Down a little
- When you have sold a call and the currency pair goes down a little,
you reach the maximum gain on the trade. When you sell a call option,
you receive the premium up front. If the currency pair goes down a little,
you get to keep the entire premium (your maximum gain). You can see how
the blue profit/loss line remains flat at its highest level below the
strike price.
Down a lot
- When you have sold a call and the currency pair goes down a lot, you
reach the maximum gain on the trade. When you sell a call option, you
receive the premium up front. If the currency pair goes down a lot, you
get to keep the entire premium (your maximum gain). You can see how the
blue profit/loss line remains flat at its highest level below the strike
price.
In review, here are the results you can expect from different price action
when you buy a call option.
| PRICE
ACTION |
RESULT |
| Up a Lot |
Maximize Losses |
| Up a Little |
Maximize Losses |
| Flat |
Achieve Maximum Gain |
| Down a Little |
Achieve Maximum Gain |
| Down a Lot |
Achieve Maximum Gain |
Selling a Put Option
Selling a put option, or going short the put option, is a bullish option
trade - which means you want the underlying currency pair to go down up
value. If the currency pair goes up, you will maximize your profits on
your put trade.
Unfortunately currency pairs don't always do what you want them to do
in the forex market, and you need to know what will happen to your call
option in various scenarios. A currency pair can do one of the following
five things:
- Go up a lot
- Go up a little
- Remain flat
- Go down a little
- Go down a lot
Up a Lot
- When you have sold a put and the currency pair moves up a lot, you reach
the maximum gain on the trade. When you sell a put option, you receive
the premium up front. If the currency pair goes up a lot, you get to keep
the entire premium (your maximum gain). You can see how the blue profit/loss
line remains flat at its highest level above the strike price.
Up a Little
- When you have sold a put and the currency pair moves up a little, you
reach the maximum gain on the trade. When you sell a put option, you receive
the premium up front. If the currency pair goes up a little, you get to
keep the entire premium (your maximum gain). You can see how the blue
profit/loss line remains flat at its highest level above the strike price.
Flat -
When you have sold a put and the currency pair remains flat, you reach
the maximum gain on the trade. When you sell a put option, you receive
the premium up front. If the currency pair remains flat, you get to keep
the entire premium (your maximum gain). You can see how the blue profit/loss
line reaches its highest level at the strike price.
Down a little
- When you have sold a put and the currency pair goes down a little, you
minimize your gains on the trade. Every pip lower the currency pair moves
below the strike price for the put option reduces your gains. You can
see how the blue profit/loss line starts to fall after it crosses the
strike price level but that it is still above breakeven.
Down a lot
- When you have sold a put and the currency pair goes down a lot, you
maximize your losses on the trade. Every pip lower the currency pair moves
below the breakeven point for the put option costs you more money. You
can see how the blue profit/loss line continues to fall after it crosses
the breakeven point.
In review, here are the results you can expect from different price action
when you buy a call option.
| PRICE
ACTION |
RESULT |
| Up a Lot |
Achieve Maximum Gain |
| Up a Little |
Achieve Maximum Gain |
| Flat |
Achieve Maximum Gain |
| Down a Little |
Minimize Losses |
| Down a Lot |
Minimize Losses |
Reading a Risk Graph
Risk graphs are a simple tool you can use to visualize what the result
of your option trade will be in various market situations. Risk graphs
illustrate what the result of your option trade will be if the currency
pair does any of the following:
- Go up a lot
- Go up a little
- Remain flat
- Go down a little
- Go down a lot
As you look at a risk graph, you will see the following components (we
will use a risk graph for a long call to illustrate):
Profit/Loss axis - the vertical
axis on the left of the chart that shows the profit/loss you will receive.
For example, Point C shows a profit along the profit/loss axis, while
Point D shows a loss along the profit/loss axis.
Currency price axis - the
horizontal axis that runs through the middle of the chart represents the
price of the currency pair. Prices run lower to higher from left to right.
For example, Point C is at a higher price than Point D.
Profit/Loss line - the blue
line that runs through the chart shows the profit/loss you will receive
at any given price along the chart. For example, Point C shows you will
receive a profit when the currency pair is at a higher price, while Point
D shows you will receive a loss when the currency pair is at a lower price.
Strike price - the price
at which the option holder can exercise an option. The strike price is
represented by Point A on the chart. Remember, calls become profitable
above the strike price while puts become profitable below the strike price.
Breakeven point - the point
at which you neither make money nor lose money on your option trade. The
breakeven point is represented by Point B on the chart. Remember, the
breakeven point for calls is always above the strike price while the breakeven
point for puts is always below the strike price.
In review, here are the results you can expect from different price action
when you buy a call option.
Option Characteristics
