OPTIONS EDUCATION GLOBAL

Transcription

1 OPTIONS EDUCATION GLOBAL

2 TABLE OF CONTENTS Introduction What are FX Options? Trading 101 ITM, ATM and OTM Options Trading Strategies Glossary Contact Information HIGH RISK WARNING: Before you decide to trade either foreign currency ( Forex ) or options, carefully consider your investment objectives, experience level, and risk tolerance. Over the counter leveraged Forex spot trading ( spot trading ) and options trading ( options trading ) both carry high levels of risk that may not be suitable for all investors. Educate yourself on the risks associated with spot and options trading, and seek advice from an independent fi nancial or tax advisor if you have any questions. With spot trading, you could lose some or all of your initial investment; do not invest money that you cannot afford to lose. Leverage, offered as part of spot trading, creates additional risk and loss exposure. With options trading, you could not only lose all of your initial investment, but the potential to lose money is potentially unlimited when you write an option. Purchasers and sellers of Forex options should familiarize themselves with the type of option (i.e., put or call) that they contemplate trading and the associated risks. You should calculate the extent to which the value of the options must increase for your position to become profi table, taking into account the premium paid, other transaction costs, if any, and rate of premium/time decay.

3 INTRODUCTION WELCOME TO FXDD S INTRODUCTION TO OPTIONS GUIDE! FX options are a smart investment alternative for traders of all experience levels. Throughout the course of this guide, you will learn the basic trading terms and a few strategies to help you get started on the right foot. Let s get started by explaining what an option is. To keep it simple, we will use the example of options on stocks to illustrate the comparison. WHAT IS A STOCK VERSUS AN OPTION? When a stock is purchased, it signifi es that the buyer now owns a claim to the company and its assets. This means that when a company s stock value rises, so too does the value of the owner s stock. Similarly, when the company s stock value falls, the value of the owner s stock also falls. An option, on the other hand, is a contract to buy or sell an asset (whether it is a stock or currency) in the future. However, an options contract holder is not obligated to go through with, or exercise, the purchase or sale of the underlying asset. Thus, a stock option allows the trader to take a position on the company without actually having to own the stock. THANKS TO THE NATURE OF THE FOREX MARKET, FX OPTIONS OFFER CERTAIN ADVANTAGES OVER THEIR EQUITY OPTION COUNTERPARTS. OPTIONS MITIGATE RISK When a stock trader owns a stake in a company, his risk exposure correlates directly to the company s performance. If the price of the stock falls, the trader will incur losses. Option traders pay a fi xed premium to buy an options contract, since they are not obligated to exercise the contract. A stock options trader could protect his profi ts in case of a falling stock price with a put for a fi xed premium cost, but does not have to exercise the contract if the price keeps going up. Forex traders participate in a much faster-paced, higher-risk and more volatile market. FX options offer similar risk protection to mitigate the potentially harmful effects of unexpected market swings. OPTIONS EDUCATION 3

4 TRADING AROUND THE WORLD Stocks and stock options are commonly traded on an exchange, meaning that traders can only trade during the certain designated hours that the exchange is open. In contrast, the FX market is a decentralized exchange that operates seamlessly through international fi nancial centers across the world. FX options traders can take advantage of this unique trading environment by capitalizing on opportunities 24 hours a day, 5.5 days a week. LOWER TRADING COSTS The premium, or cost to buy an option, is denominated using the same metric as the price of the underlying asset. Thus, stocks and stock options are denominated in USD (or other local currency) per share. Forex trades approximately $4 trillion per day, making it a highly liquid market. The frequent and sizable trades make FX a competitive landscape for brokerages and banks. Competition drives down the cost of execution, resulting in spreads that are tighter than any other asset class. LEVERAGE/MARGIN Forex traders outside of the United States can trade with leverage of up to 200:1. With FXDD, we allow 100:1 leverage, or trading with 1% margin. In comparison, when buying a stock, traders must pay the full value for their stake in that company, essentially getting 1:1 leverage. FX OPTIONS TRADER PROFILE Do you have what it takes to be an FX options trader? Let s take a look at our average trader. Trader: Johnny Options Minimum Deposit: $5,000 Average Deposit: $15,000 Trading Experience: Options on US Stocks Trading Platform: FXDD Options Trader Johnny Options is a middle-aged trader who has extensive experience trading equity options. He has never traded currencies but is intrigued by FX options because of the 24-hour trading day. Instead of ending his trading at 4:00 pm, like other stock and equity options traders, Johnny has more flexibility to fi nd tradable opportunities around the clock. OPTIONS EDUCATION 4

5 WHAT ARE FX OPTIONS? FX OPTIONS ARE FINANCIAL CONTRACTS BETWEEN TRADERS AND DEALERS While more traditional stock options are traded on an exchange, FX options are contracts that traders and dealers enter into with one another when they buy and sell to each other. A trader can either buy an FX option from a dealer or sell an FX option to a dealer. The person buying an options contract is the holder and the person selling an options contract is the writer. WRITER HOLDER THERE ARE TWO FUNDAMENTAL TYPES OF FX OPTIONS A call option gives the holder the right (but not the obligation) to buy from the writer so many units of a currency at a specifi ed price, known as the strike price. A put option gives the holder the right (but not the obligation) to sell to the writer so many units of a currency at a specifi c price, known as the strike price. The strike price, also known as the exercise price, is the stated price that the buyer of a call can buy a specifi c currency at, or the stated price that the buyer of a put can sell a specifi c currency at. CONTRACT SIZE An option s size specifi es the number of units of currency that one option contract leverages. Contract sizes are different for options written on different currency pairs. CURRENCY PAIRS FX options contracts are quoted in base/quote currency pairs. The base currency is known as the underlying currency. You always buy and sell foreign currencies with your domestic currency and buy and sell foreign currency options with your domestic currency. EUR/USD BASE QUOTE For example, a spot price for EUR/USD of 1.5 means that 1 euro costs $1.5. A EUR/USD call option with a strike price of 1.6 and an ask price of.02 would cost the buyer $.02 and give him the right to purchase euros at a price of $1.6 per euro. The ask price is the price at which the spot market or an option can be bought. The bid price is the price at which the spot market or an option can be sold. The spot price is the available rate for an immediate exchange of currency. To incorporate the base/quote price-quoting convention into our defi nitions, a call option gives the holder the right to buy so many units of the base currency from the writer at a strike price expressed in the quote currency. A put option gives the holder the right to sell to the writer so many units of the base currency at a strike price expressed in the quote currency. OPTIONS EDUCATION 5

6 TRADING 101 WHEN YOU BUY OPTIONS, YOU CREATE A LONG POSITION. WHEN YOU SELL OPTIONS (WRITE AN OPTION), YOU CREATE A SHORT POSITION. If you think a currency s price will rise, buy calls or sell puts. If you think a currency s price will fall, buy puts or sell calls. If you believe the price of a base currency is likely to rise relative to a quote currency, then, as a simple trading strategy, you may want to buy calls or sell puts. That is, you may want to go long calls or short puts. If you believe the price of a base currency is likely to fall relative to a quote currency, then you may want to buy (go long) puts or sell (go short) calls. If you buy an FX call or a put, you pay for the option in the quote currency. If you sell an FX call or put, you have been paid for it in the quote currency. For every options contract, there is an expiration date. Upon expiration, an option can no longer be traded or exercised. For a given currency pair, dealers quote prices for options that have different strike prices and expiration dates. A dealer s price quotes sort options by their strike prices and expiry months and years. Typically, options expire in the third week of the month or the end of the month. Each dealer handles expiration differently. PRICE RISES PRICE FALLS = BUY CALLS OR SELL PUTS TO PROFIT. = SELL CALLS OR BUY PUTS TO PROFIT. FXDD S FX OPTIONS ARE EUROPEAN STYLE, MEANING THEY CAN ONLY BE EXERCISED AT EXPIRATION. Exercising an option means that you take advantage of your right to buy or sell at the strike price. If you exercise a call option, you sell your call option for a premium and you go long the spot market at the strike price. If you exercise a put option, you sell your put option for a premium and you go short the spot market at the strike price. OPTIONS EDUCATION 6

7 TRADING OPTIONS WITH FXDD An option s price or premium is the amount of money the buyer pays to enter into the contract. Dealers quote option prices in the quote currency at a price per unit of the base currency. The total price that the buyer pays to enter into one contract is (Quoted Price) x (Contract Size), then converted into the dealer s deposit currency such as dollars, euros or yen. Dealers quote different ask and bid prices. The ask price is the price at which the dealer will sell you an option. The bid price is the price at which the dealer will pay for an option. - At a given moment in time, for a given option, a dealer s ask price is always higher than their bid price. The bid-ask spread is a main source of a dealer s compensation. FX CALL AND PUT CONTRACT SPECIFICATIONS Whether you are engaging in an FX call or FX put option, there are certain components involved. A call option gives the holder the right to buy so many units of the base currency from the writer at a strike price expressed in the quote currency. A put option gives the holder the right to sell to the writer so many units of the base currency at a strike price expressed in the quote currency. ELEMENTS OF AN FX OPTION FX CALL OPTION Base/quote currency pair Strike price is the price expressed in the quote currency at which the holder is entitled to buy the base currency from the writer. Contract size is the number of units of base currency that the holder is entitled to buy from the writer. Expiration date Option price or premium to be paid in quote currency. FX PUT OPTION Base/quote currency pair Strike price is the price expressed in the quote currency at which the holder is entitled to sell the base currency to the writer. Contract size is the number of units of base currency that the holder is entitled to sell to the writer. Expiration date Option price or premium to be paid in quote currency. OPTIONS EDUCATION 7

8 ITM, ATM AND OTM IN THE MONEY (ITM) A call option is in the money if the market price of the base currency is greater than the option s strike price. A put option is in the money if the market price of the base currency is less than the option s strike price. Price OTM CALLS ITM PUTS Current Value AT THE MONEY (ATM) A call option is at the money if the price of the base currency is equal or closest to the options strike price. A put option is at the money if the base currency is equal or closest to the options strike price. OUT OF THE MONEY (OTM) A call option is out of the money if the option s strike price is greater than the market price of the base currency. A put option is out of the money if the option s strike price is less than the market price of the base currency. WHAT HAPPENS WHEN MY OPTION EXPIRES? OTM PUTS ITM CALLS Time A call option is in the money if the market price of the base currency is greater than the option s strike price. A put option is in the money if the market price of the base currency is less than the option s strike price. If, at the time a call expires, the base/quote spot price is above the option s strike price, then the option has a positive payoff: Call Payoff = Spot Price Strike Price If, at the time a put expires, the base/quote spot price is below the option s strike price, then the option has a positive payoff: Put Payoff = Strike Price Spot Price If an option expires with a positive payoff, then the holder may either exercise the option or accept a cash settlement. If the holder exercises a call, he or she buys the underlying currency from the writer at the call s strike price. If the holder exercises a put, he or she sells the underlying currency to the writer at the put s strike price. If the option has a positive payoff and the option settles in cash, then the holder receives from the writer a cash settlement: Cash Settlement = Payoff x Contract Size OPTIONS EDUCATION 8

9 OPTIONS TRADING STRATEGIES Whether trading in a volatile or stagnant market, FX options present opportunities and strategies for any market condition. Two of these strategies are straddles and strangles. Straddles are options strategies executed by buying or selling both a call option and a put option with the same strike and expiration. Strangles are options strategies executed by buying or selling both a call option with a lower strike price and a put option with a higher strike price with the same expiration. Long Strangles/Straddles are both strategies that allow the trader to gain on signifi cant moves either up or down in a currency s price. These strategies are good for volatile markets. Short Strangles/Straddles are both strategies that allow the trader to gain on the lack of signifi cant moves in a currency s price. These strategies are good for stagnant markets. As a general rule, traders prefer to sell straddles and buy strangles when the expiration date is far in the future; conversely, they prefer to buy straddles and sell strangles when the expiration date is in the near future. STRADDLES If the trader expects a currency to make a large move one way or the other but doesn t know which, he or she may wish to establish a long straddle. If, at expiration, the price of the underlying currency has gone up or down by more than the combined cost of the two options, the trader will profit. The trader s maximum potential loss is the cost of setting up the straddle. STRANGLES If a trader expects a currency to hold a target or range, he/she may wish to establish a position called a short strangle. To implement a short strangle, the trader sells a put and a call that have the same time to expiration but different strike prices. The overall goal of this strategy is to let the options expire worthless or to buy them back at a lower price. If the call has a higher strike price than the put, then if the price of the underlying currency is between the two strike prices at expiration, both the call and the put will expire worthless. Profi t from upward price movement Lose if price is flat Profi t from downward price movement Lose from upward price movement Profi t if price is flat Lose from downward price movement Be advised that this strategy, like all short strategies, carries a potentially unlimited risk. OPTIONS EDUCATION 9

10 GLOSSARY

11 OPTIONS GLOSSARY Ask: The price at which the spot market or an option can be bought. Same as an offer. Assignment: The process of turning a short option into a spot position. At the Money: This term refers to an option whose strike price is equal to the current spot market price. Base Currency: In a cross rate or currency pair, the currency that remains constant when determining the price. The base currency appears fi rst in a currency pair symbol. Basis Point: The standard unit used to describe the change in an option s value. For example, 1 basis point (0.01%) is equal to 1 pip in spot FX. Bearish: This term is used to describe a market sentiment that the price of a commodity will fall. Bear Spread: This options strategy is executed by buying an option with a higher strike and selling an option with a lower strike. The options can either both be calls or both puts, but they must have the same expiration. Bid: The price at which the spot market or an option can be sold. Breakeven: The market price at which a position earns neither a profi t nor loss. Bullish: This term is used to describe a market sentiment that the price of a commodity will rise. Bull Spread: This options strategy is executed by buying an option with a lower strike and selling an option with a higher strike. The options can either both be calls or both puts, but they must have the same expiration. Calendar Spread: This options strategy is executed by selling an option with a shorter expiration and buying an option with a longer expiration. The options can either both be calls or both puts, but they must have the same strike price. OPTIONS EDUCATION 11

12 Call (Option): A fi nancial instrument that gives the owner the right to buy a quantity of a spot market at a specifi c price within a specifi c time. Collar: An option strategy executed by selling (or buying) a put and buying (or selling) a call with different strikes but the same expiration. Covered Call (Covered Write): An option strategy executed by buying the spot market and selling an equivalent number of call options. Credit Spread: A spread position that results in a cash inflow. Cross (Rate): The rate of exchange between two currencies if one is not a major currency. Currency Pair: The rate of exchange between two currencies. Debit Spread: A spread position that results in a cash outflow. Delta: The rate that an option s premium changes relative to a change in the spot market if all other factors remain constant. Diagonal Spread: An option strategy executed by selling an option with a shorter expiration and buying an option with a longer expiration. The options can either both be calls or both puts, but they must have different strike prices. European Style: Options that can only be exercised into a spot position upon expiration. Exercise: The process of turning a long option into a spot position. Exercise Price (Strike Price): The price at which an option owner can buy or sell the spot market upon option exercise. Expiration: The termination of an option. Upon expiration, an option can no longer be traded or exercised. Gamma: The rate that an option s delta changes relative to a change in the spot market if all other market factors remain constant. Hedge: A position that offsets the risk associated with another position. In the Money: This term refers to an option that has intrinsic value. Call options are in the money if the spot price is greater than the strike price. Put options are in the money if the spot price is less than the strike price. OPTIONS EDUCATION 12

13 Intrinsic Value: The profi t that would result if an option were immediately exercised. It is also the amount that an option is in the money. For call options, the intrinsic value is equal to zero, or the spot price minus the strike price, whichever is greater. For put options, the intrinsic value is equal to zero, or the strike price minus the spot price, whichever is greater. Limit Order: An order to buy or sell at a specifi c price (limit), or at a price that is more benefi cial to the trader. Long: This term refers to an inventory of spot positions and/or options that have been bought. Margin: The amount of capital that must be allocated toward offsetting the risk associated with a position. Market Order: An order to buy at the current bid price or sell at the current ask price. Naked: This term refers to a short option position that is not covered. Near the Money: This term refers to an option whose strike price is nearly equal to the current spot market price. Offer: The price at which the spot market or an option can be bought. Same as an ask. Offset: A trade that liquidates a current position. Option: A fi nancial instrument that allows the owner the right to buy or sell a quantity of a spot market at a specifi c price within a specifi c time. Order: An instruction to buy or sell the spot market or an option. Out of the Money: This term refers to an option that has no intrinsic value. Call options are out of the money if the spot price is less than the strike price. Put options are out of the money if the spot price is greater than the strike price. Pip: The smallest increment that a spot market price can change. Premium: The price of an option. Psi: The amount that an option s price changes for a 1% (i.e., from 2% to 3%) change in the foreign interest rate if all other market factors remain constant. Put (Option): A fi nancial instrument that allows the owner the right to sell a quantity of a spot market at a specifi c price within a specifi c time. OPTIONS EDUCATION 13

14 Quote Currency: In a cross rate or currency pair, the currency that varies when determining the price. The quote currency appears second in a currency pair symbol. Rho: The amount that an option s price changes for a 1% (i.e., from 2% to 3%) change in the domestic interest rate if all other market factors remain constant. Short: This term refers to a spot position or option that has been sold. Spot (Market): The available rate for an immediate exchange of currency. Spread: The difference between the bid and ask. Spread Position: A position composed of a long option and a short option of the same type. Stop Order: An order type designating the execution of a market order when the market reaches a specifi c price (stop). Stop-Limit Order: An order type designating the execution of a limit order when the market reaches a specifi c price (stop). Straddle: An option strategy executed by buying or selling both a call option and a put option with the same strike and expiration. Strangle: An option strategy executed by buying or selling both a call option with a lower strike price and a put option with a higher strike price with the same expiration. Strike Price: The price at which an option owner can buy or sell the spot market upon their option being exercised. Synthetic Call: An option strategy executed by buying (or selling) the spot market and buying (or selling) a put. The profi t and loss associated with this position are equivalent to buying (or selling) a call with the same strike and expiration. Synthetic Put: An option strategy executed by selling (or buying) the spot market and buying (or selling) a call. The profi t and loss associated with this position are equivalent to buying (or selling) a put with the same strike and expiration. Synthetic Spot: An option strategy executed by selling (or buying) a put and buying (or selling) a call with the same strike and expiration. The profi t and loss associated with this position are equivalent to buying (or selling) the spot market. OPTIONS EDUCATION 14

15 Theta: The amount an option s value will change over time if all other market factors remain constant. Time Value: The amount of an option s value that is in excess of intrinsic value. Type: The classifi cation of an option, defi ned as either an option to buy (call) or an option to sell (put). Vega: The amount that an option s price changes for a 1% (i.e., from 12% to 13%) change in volatility if all other market factors remain constant. Vertical Spread: An option strategy executed by buying and selling options with different strikes but the same expiration. Volatility: A measure of the variation in the spot price. Write (an Option): To sell an option. OPTIONS EDUCATION 15

16 ASK FXDD DO YOU HAVE QUESTIONS ABOUT FX OPTIONS? ASK FXDD! FXDD IS TAKING ITS EDUCATION TO SOCIAL MEDIA. LOG IN TO YOUR PERSONAL ACCOUNT AND ASK US YOUR FOREX TRADING QUESTIONS. WE WILL PUBLISH THE ANSWERS TO YOUR QUESTIONS ON YOUTUBE, FACEBOOK AND TWITTER! CONTACT INFORMATION IF YOU D LIKE MORE INFORMATION ON FXDD AND TRADING FX OPTIONS, WE D LOVE TO HEAR FROM YOU! LIVE CHAT: Talk to a Forex specialist in real time. CALL US: US: sales@fxdd.com.mt CONTINUE YOUR EDUCATION: OPTIONS EDUCATION 16