Education > Forex - Step7

[SECTION 3.1]

Forex options

Forex options are the next frontier in forex trading. Forex options are as it says on the box, options in forex trading. If unparalleled flexibility in your trading is what you have been after, then is the place for you.

Saxo Bank has the most comprehensive forex option trading platform in the industry. It's impossible to find a simpler way of buying and selling currency pairs.

Forex options let you not only benefit from movements in a currency pair but also limit the risk to which you are exposed. You can make money with options when currency pairs are on the up, when pairs are going down and even when currency pairs are moving sideways.

In this section, we will look at standard options first. It is the basis on which you can build your option trading. Standard options are also referred to as vanilla options because they are plain and simple. In subsequent sections, we will discuss exotic options, those options with extra frills that you can use in particular scenarios.

In this options section, we will explain the following to prepare you for your first option trade:

1. What vanilla options you can trade?calls and puts [SECTION 3.1.1]
2. What affects option values?option Greeks [SECTION 3.1.2]
3. What type of option trader you will be?buyer or seller [SECTION 3.1.3]

[SECTION 3.1.1]

Vanilla options-calls and puts

Vanilla options come in two varieties: calls and puts. Call options give you the discretionary right to buy a currency pair at a certain price on or before a given date. Put options give you the discretionary right to sell a pair at a certain price on or prior to a given date.

You can 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 benefit from the upward movement of the currency pair. If you believe a pair is going to go down, you can either buy a put option or sell a call option to cash in on the downward movement of the currency pair.

You will learn more about how to make use of options later in this section when we look at the type of an option trader you may choose to be. For now, it is important that you absorb the basics of options and how they work so you can use them appropriately in your forex trading. Take a moment to become familiar with the following:

1. Unique characteristics of forex options [SECTION 3.1.1.1]
2. Value of a forex option [SECTION 3.1.1.2]

[SECTION 3.1.1.1]

Option characteristics

Forex options are unique, multi-dimensional trading tools that allow you tremendous flexibility in your investing. But if you want to successfully utilise them in your own portfolio, you need to become familiar with their distinctive traits.

Every vanilla option has the following three characteristics:

1. 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 sell a currency pair (if you have bought a put option or sold a call option).
2. Expiry date: This date signifies when the option expires, or becomes worthless, if nobody exercises it.
3. 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 at any time up to December 21.

[SECTION 3.1.1.2]

The value of an option

The value of an option has two elements: intrinsic value and time value.
Intrinsic value: Market convention refers to the price of the underlying asset minus the strike of the option as the option's intrinsic value (that is, for a call option. But for a put it would of course be the opposite). Theoretically, one could argue that the forward rate of the underlying asset is more useful than the spot, but market convention is to use the spot.
Time value: Put simply, 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 goes up as volatility increases because of the profit/loss scenario for an option. As mentioned before, 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 that on a less volatile asset.
Interest rates differentials in the two currencies involved in a currency option trade must also be factored into your thinking when pricing an option, as they are also a function of time.
This graph illustrates how a call option is priced according to how close the asset price is to the strike price for the option (see figure 1).

Figure 1?Option pricing graph
In this example, let's say 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 30 days prior to the option's expiry. 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 scenario, 70 pips).

[SECTION 3.1.2]

Option Greeks

Option prices are affected by five factors, each of which has a fun Greek name to represent it. As you develop as a forex option trader, the following options Greeks will emerge on a regular basis:

1. Delta
2. Gamma
3. Theta
4. Vega
5. Rho

Delta: Delta describes how the value of an option is changed by small changes in the underlying asset, assuming that all the other factors impacting option pricing remain equal. The delta of an option can also be seen 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: Gamma identifies how the delta of the option is altered by underlying asset changes. Hence, the gamma also helps you 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 gives an insight into the investor's perspective on the volatility of the underlying asset. A long position illustrates an expectation that the market is volatile. A short position suggests that investors anticipate a calm market.
Theta: Theta identifies the change in the value of the option as time passes and all else remains equal. This change stems from the stance that the time leading up to an option's expiration lessens as time goes by. This change in value is also often referred to the amount that the option 'bleeds' the speculator. The theta (sensitivity) is often noted in pips lost in value per day that passes.

Vega: Vega illustrates the change in the value of the option when volatility is altered. The volatility represents the degree of the swing in the underlying asset and is the fulcrum in option pricing. Larger swings suggest that the underlying asset will probably take on more extreme values. And, though the option holder's risk is limited to the premium, his/her upside is unlimited for vanilla options. Hence, a rise in the volatility of the base asset raises the value of the option. As the table below indicates, the sensitivity is larger the closer to ATM (ATM??????) �the option is and the longer there is until expiry.

Rho: 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 excludes 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).

Learning reinforcement exercise

Match the following Greeks with the factors they measure:

Vega - Change in time
Rho - Change in Delta
Delta - Change in volatility
Theta - Change in price
Gamma - Change in interest rates

[SECTION 3.1.3]

Option �buyers and option sellers

Forex option traders can elect to be 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 who go into a trade by selling either a call or a put option. Your decision to buy or sell an option contract will depend on whether you feel bullish or bearish on a currency pair.

You can make money with forex options whether currency pairs are going up, down or sideways.

1. Up: If your fundamental and technical analysis tells you that the currency pair is going to move up, you can either buy a call option or sell a put option.
2. Down: If your analysis says that the currency pair is going to go down, you can either buy a put option or sell a call option.
3. Sideways: If your analysis tells you that the currency pair is going to move sideways, you can either sell a call option or sell a put option.

Buying a call or a put option allows you to leverage virtually unlimited profits so long as the currency pair keeps rising if you bought a call option or continues to slip if you bought a put option. However, the currency pair must move far enough to overcome the initial premium you paid for the option.

Selling a call or a put option lets you take your profits up front and keep the full profit so long as the currency pair remains below the strike price of the call you sold or above the strike price of the put you have sold. But if the currency pair goes past your strike price, you can lose more money than you collected by selling the option.

Let's examine how each of the following option trades develop in various market conditions (assuming you buy or sell at-the-money* options):

1. Buying a call option [SECTION 3.1.3.1]
2. Buying a put option [SECTION 3.1.3.2]
3. Selling a call option [SECTION 3.1.3.3]
4. Selling a put option [SECTION 3.1.3.4]

But before you do that, you need to become familiar with a risk graph. A risk graph is �the tool we will use to demonstrate the effect a variety of market conditions will have on your option trades: [SECTION 3.1.3.5]

*At-the-money means that the strike price is the same as the current price of the currency pair when you enter the trade.

Extra material / cut outs

Before you attempt to trade forex options in your live account, try having a go in a demo account. It will give you the chance to familiarise yourself with how time, volatility, etc. affect your option prices before you put any of your own money at risk.

[SECTION 3.1.3.1]

Buying a call option

Buying a call option, or going long the call option, is a bullish option trade. It means you want the underlying currency pair's worth to rise. If the pair increases, your profits on your call trade will be maximised.

Unfortunately, currency pairs will not always do what you want in the forex market. Given that, you need to know what will take place with your call option in different scenarios. A currency pair can do one of the following:

1. Go up a lot
2. Go up a little
3. Remain flat
4. Go down a little
5. Go down a lot

Up a lot: When you have bought a call and the currency pair shoots up, you maximise your profits on the trade. Every pip higher the currency pair progresses 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 passes through the breakeven point (see figure 2).

Figure 2?Long call profitability as the currency pair moves up a lot

(To learn more about risk graphs like the one above, click here [SECTION 3.1.3.5])

Up a little: When you have bought a call and the currency pair goes up a little, you minimise your losses on the trade. Every pip higher the currency pair ascends past the strike price for the call option cuts your losses. The blue profit/loss line demonstrates this.� It starts to rise after it crosses the strike price level but remains below breakeven (see figure 3).

Figure 3?Long call profitability as the currency pair moves p a little

(To learn more about risk graphs like the one above, click here [SECTION 3.1.3.5])

Flat: When you have bought a call and the currency pair stays 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 (see figure 4).

Figure 4?Long call profitability as the currency pair remains flat

(To learn more about risk graphs like the one above, click here [SECTION 3.1.3.5])

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 (see figure 5).

Figure 5?Long call profitability as the currency pair moves down a little

(To learn more about risk graphs like the one above, click here [SECTION 3.1.3.5])

Down a lot: When you have bought a call and the currency pair moves 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 (see figure 6).

Figure 6?Long call profitability as the currency pair moves down a lot

(To learn more about risk graphs like the one above, click here [SECTION 3.1.3.5])

In review, the outcomes you can anticipate from different price actions when you buy a call option can be summarised here.

[SECTION 3.1.3.2]

Buying a put option

Buying a put option, or going long the put option, is a bearish option trade. It means you want the underlying currency pair's value to fall. If the pair slips, profits on your put trade will be maximised.

As we already know, currency pairs have a mind of their own in the forex market, and knowing what will happen to your put option in a variety of situations is important. A currency pair can do one of the following:

1. Go up a lot
2. Go up a little
3. Remain flat
4. Go down a little
5. Go down a lot

Up a lot: When you have bought a put and the currency pair goes 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, then the entire premium is lost (your maximum loss). You can see how the blue profit/loss line remains flat at its lowest level above the strike price (see figure 7).

Figure 7?Long put profitability as the currency pair moves up a Lot

(To learn more about risk graphs like the one above, click here [SECTION 3.1.3.5])

Up a little: When you have bought a put and the currency pair rises by 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 moves up a little, the entire premium must be paid (your maximum loss). You can see how the blue profit/loss line remains flat at its lowest level below the strike price (see figure 8).

Figure 8?Long put profitability as the currency pair moves up a little

(To learn more about risk graphs like the one above, click here [SECTION 3.1.3.5])

Flat: If you have bought a put and the currency pair stays flat, you reach the maximum loss on the trade. As when you buy a put option, you must pay the premium up front, a flat currency pair means you will lose the entire premium (your maximum loss). You can see how the blue profit/loss line reaches its lowest level at the strike price (see figure 9).

Figure 9?Long put profitability as the currency pair remains flat

(To learn more about risk graphs like the one above, click here [SECTION 3.1.3.5])

Down a little: When you have bought a put and the currency pair falls a little, you minimise your losses on the trade. Every pip lower the pair moves under the strike price for the put option cuts your loss. 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 (see figure 10).

Figure 10?Long put profitability as the currency pair moves down a little

(To learn more about risk graphs like the one above, click here [SECTION 3.1.3.5])

Down a lot: When you have bought a put and the currency pair drops a lot, your profits on the trade are maximised. Every pip lower the currency pair goes under the breakeven point for the put option increases your profit. You can see how the blue profit/loss line continues to rise after it crosses below the breakeven point (see figure 11).

Figure 11?Long put profitability as the currency pair moves down a lot

(To learn more about risk graphs like the one above, click here [SECTION 3.1.3.5])

In review, the outcomes you can anticipate from different price actions when you buy a put option are as follows

[SECTION 3.1.3.3]

Selling a call option

Selling a call option, or going short the call option, is a bearish option trade. It means you want the underlying currency pair to slip in value. If the pair goes down, your profits on your call trade will be maximised.

Currency pairs are, however, not always easy to predict in the forex market. Again, knowing what will happen to your call option in various scenarios is critical. A currency pair can do one of the following:

1. Go up a lot
2. Go up a little
3. Remain flat
4. Go down a little
5. Go down a lot

Up a lot: When you have sold a call and the currency pair spikes, your losses on the trade are maximised. Every pip that the currency pair moves beyond the breakeven point for the call option hits you in the pocket. You can see how the blue profit/loss line continues to fall after it crosses the breakeven point (see figure 12).

Figure 12?Short call profitability as the currency pair moves up a lot

(To learn more about risk graphs like the one above, click here [SECTION 3.1.3.5])

Up a little: When you have sold a call and the currency pair rises by a small amount, your gains on the trade are minimised. Every pip the currency pair moves above the strike price for the call option hits your profits. 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 (see figure 13).

Figure 13?Short call profitability as the currency pair moves up a little

(To learn more about risk graphs like the one above, click here [SECTION 3.1.3.5])

Flat: When you have sold a call and the currency pair continues to be flat, you reach the maximum gain on the trade. When you sell a call option, you get the premium up front. If the currency pair remains flat, the entire premium is yours (your maximum gain). You can see how the blue profit/loss line reaches its highest level at the strike price (see figure 14).

Figure 14?Short call profitability as the currency pair remains flat

(To learn more about risk graphs like the one above, click here [SECTION 3.1.3.5])

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 get the premium up front. If the currency pair goes down a little, you hold onto 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 (see figure 15).

Figure 15?Short call profitability as the currency pair moves down a lLitte

(To learn more about risk graphs like the one above, click here [SECTION 3.1.3.5])

Down a lot: When you have sold a call and the currency pair falls significantly, you reach the maximum gain on the trade. When you sell a call option, you get the premium up front. If the currency pair moves 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 (see figure 16).

Figure 16?Short call profitability as the currency pair moves down a lot

(To learn more about risk graphs like the one above, click here [SECTION 3.1.3.5])

In review, the outcomes you can anticipate from different price actions when you buy a call option are as follows:

[SECTION 3.1.3.4]

Selling a put option

Selling a put option, or going short the put option, is a bullish option trade. It means you need the underlying currency pair to rise in value. If the pair moves upwards, you will take full profits from your put trade.

But given the well-documented volatility of currency pairs, knowing what may happen to your call option in different scenarios is important. A currency pair can do any of the following:

1. Go up a lot
2. Go up a little
3. Remain flat
4. Go down a little
5. Go down a lot

Up a Lot: When you have sold a put and the currency pair moves up a lot, you will get the full gain on the trade. As when you sell a put option, you receive the premium up front, you will get to keep the entire premium (your maximum gain) if the currency pair is on the move upwards. You can see how the blue profit/loss line remains flat at its highest level above the strike price (see figure 17).

Figure 17?Short put profitability as the currency pair moves up a lot

(To learn more about risk graphs like the one above, click here [SECTION 3.1.3.5])

Up a little: When you have sold a put and the currency pair rises only by a small amount, you attain the maximum gain on the trade. When you sell a put option, you get the premium up front. If the currency pair rises by a little, you get to hold on to 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 (see figure 18).

Figure 18?Short put profitability as the currency pair moves up a little

(To learn more about risk graphs like the one above, click here [SECTION 3.1.3.5])

Flat: You reach the maximum gain on the trade when you have sold a put and the currency pair stays flat,. When you sell a put option, you get the premium up front. If the pair continues to be 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 (see figure 19).

Figure 19?Short put profitability as the currency pair remains flat

(To learn more about risk graphs like the one above, click here [SECTION 3.1.3.5])

Down a little: When you have sold a put and the currency pair falls by a small amount, your gains on the trade are minimised. Every pip by which the pair undercuts the strike price for the put option eats into your profit. 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 (see figure 20).

Figure 20?Short put profitability as the currency pair moves down a little

(To learn more about risk graphs like the one above, click here [SECTION 3.1.3.5])

Down a lot: When you have decided to sell a put and the currency pair falls significantly, your losses on the trade will be maximised. Every pip by which the currency pair slips under the breakeven point for the put option hits you in the pocket. You can see how the blue profit/loss line continues to fall after it crosses the breakeven point (see figure 21).

Figure 21?Short put profitability as the currency pair moves down a lot

(To learn more about risk graphs like the one above, click here [SECTION 3.1.3.5])

To sum up, the outcomes you can anticipate from different price actions when you buy a call option are as follows:

[SECTION 3.1.3.5]

Reading a Risk Graph

You can use risk graphs to visualise the result that your option trade will lead to in different market scenarios. An easy-to-use tool, risk graphs show the result of your option trade if the currency pair does any of the following:

1. Go up a lot
2. Go up a little
3. Remain flat
4. Go down a little
5. Go down a lot

The risk graph (see figure 22) consists of the following elements (we will use a risk graph for a long call for demonstration):

1. Profit/Loss axis: This is the vertical axis to the left of the chart and it depicts the profit/loss you will get. For example, point C illustrates a profit along the profit/loss axis. Point D however, shows a loss along the profit/loss axis.

1. Currency price axis: This is the horizontal axis running down the centre of the chart and it depicts the price of the currency pair. Prices run lower to higher from left to right. For example, point C is a higher price than point D.

1. Profit/Loss line: This is the blue line which illustrates the profit/loss at any given price along the chart. For example, C marks the point at which you will receive a profit when the currency pair is at a higher price. But point D is a position at which you will be in loss-making territory when the pair is at a lower price.

1. Strike price: This is the price where the option holder can use an option. The strike price here is point A. Remember, calls become money-making above the strike price but puts increase your profit beneath the strike price.

1. Breakeven point: This is where you are effectively in stalemate. You neither make nor lose money on your option trade. Here, point B marks the spot. Never forget that the breakeven point for calls must always be above the strike price. Similarly, the breakeven point for puts must always be found under the strike price.

Figure 22?Risk graph