# Chapter 3.4. Forex Options

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1 Chapter 3.4 Forex Options 0

4 For example, you can buy a call option on the EUR/USD with a strike price of 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 at any time before December 21. THE VALUE OF AN OPTION The value of an option has two elements: intrinsic value and time value. 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. 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. 3

5 Let's say that you hold a Call option with a strike price, and that the market price of EUR/USD has risen to 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 and the market price is 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 fun 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 4

6 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 5

9 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 8

10 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. 9

11 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. 10

12 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. 11

13 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. 12

14 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. 13

15 In review, here are the results you can expect from different price action when you buy a call option. PRICE ACTION Up a Lot Up a Little Flat Down a Little Down a Lot RESULT Maximize Gains Minimize Losses Achieve Maximum Loss Achieve Maximum Loss 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 14

16 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. 15

17 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. 16

18 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. 17

19 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. 18

20 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. 19

21 In review, here are the results you can expect from different price action when you buy a put option. PRICE ACTION Up a Lot Up a Little Flat Down a Little Down a Lot RESULT Achieve Maximum Loss Achieve Maximum Loss Achieve Maximum Loss Minimize Losses 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 20

22 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. 21

23 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. 22

24 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. 23

25 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. 24

26 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. 25

27 In review, here are the results you can expect from different price action when you buy a call option. PRICE ACTION Up a Lot Up a Little Flat Down a Little Down a Lot RESULT Maximize Losses Minimize Losses Achieve Maximum Gain Achieve Maximum Gain 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 26

28 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. 27

29 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. 28

30 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. 29

31 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. 30

32 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. 31

33 In review, here are the results you can expect from different price action when you buy a call option. PRICE ACTION Up a Lot Up a Little Flat Down a Little Down a Lot RESULT Achieve Maximum Gain Achieve Maximum Gain Achieve Maximum Gain Minimize Losses Maximize 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): 32

34 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. 33

37 Once you have identified the time frame you should be using for your trend chart, all you need to do is determine what the prevailing trend on the chart is. You can use diagonal support and resistance levels or moving averages to identify the trend. You can see on the weekly EUR/USD here that both the diagonal support level and the moving average indicate that this currency pair is in an uptrend. 36

41 HIGH-PROBABILITY TRADE SETUP Let s take a look at what a high-probability trade setup looks like using the multiple time-frame trading approach. We will be looking at an example of the EUR/USD using a weekly chart as the trend chart, a daily chart as the signal chart and a 1-hour chart as the timing chart. First, you look at your trend chart to see what direction the currency is trending. As you can see on the EUR/USD weekly chart, the currency pair has been in an upward trend for some time now. It would be foolish to fight this trend and try to sell the EUR/USD. 40

42 41 Next, you look at the signal chart to identify an appropriate buy signal for the EUR/USD. In this example, we are looking at using the commodity channel index (CCI) to generate the trading signal. You can see on the daily EUR/USD chart that the CCI gave a buy signal on 10 October 2007 as it crossed from below -100 to above The trend on the daily EUR/USD chart was also moving higher.

43 42 Lastly, you look at the timing chart to identify an appropriate time to buy the EUR/USD. You can see on the 1-hour EUR/USD chart that the currency pair is in an uptrend at the time the trading signal was given on the signal chart. You can also see that the CCI on the 1-hour chart had just given a buy signal at approximately the same time the CCI on the signal chart had generated its signal.

44 Seeing the trading signal generated on the signal chart line up so well with the trend on the trend chart and the currency movement on the timing chart should give you increased confidence in the probability of your trade making you money. Using multiple time frames provides you with more accurate trading information. Better information leads to better trades. Better trades lead to more profits and a happier you! 43

45 44

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