Currency Options Basics
As part of our currency options basics education we present this short course for trading currency options. Using plain vanilla puts and calls on the spot forex can provide a currency trader with the following advantages:
Protecting profitable spot forex positions for any period of time
Preventing losses on spot positions for any period of time
Generating extra income on spot forex positions you buy or sell
Generating extra income without owning a spot forex position
Profiting from forex market movement in either direction when no trend exists
Trading with a known dollar amount at risk and known potential reward every time
Making money in a sideways (non trending) market
There are several forex options brokers that offer satisfactory trading platforms with vanilla options like puts and calls that can be used with the Forexearlywarning trading system.
Things To Remember About Options
Options are an asset class like stocks, bonds, mutual funds and commodities, they are in their own asset class. You can own an option without owning a currency pair.
You can own an option with a currency pair. With a covered call you have a buy position and a short option position in the same account. In all of the examples in this short course we specify 1 standard lot (10 mini lots) equal to 1 option contract in the examples we use, but you can trade options on mini lots if you wish, check with your options broker.
Why Some Forex Traders Are Afraid of Options - The general answer is ... a lack of education and demo trading. Traders hear others say options are risky or they hear jargon like “bull put spread” and get scared off. Educate yourself well and remember that options are for risk reduction, that’s why the professionals use them.
Who Should Attempt to Trade Currency Options
If you are a spot forex trader and are making consistent pips you should learn all there is about currency options. If you are still learning to trade the currency market using multiple time frames and parallel and inverse analysis, or are just getting started, don’t worry about currency options just yet. If you have traded puts and calls in another market like the equity market or index options and you like options then you are also a candidate for trading currency options.
Currency Options Basics - Ten Key Terms
These are example transactions for the ten key terms below. For these examples assume the EUR/USD is currently trading at 1.5500 and use 1 regular lot for the spot position size for all ten definitions below.
At-the-money - An option contract with a strike price at, (or very close to) the underlying rate; also, the closest strike price to the underlying rate. If you purchase 1 call option at 1.5500 you bought a call at-the-money.
Exercise and Assignment - All puts and calls that are in the money are exercised the day of expiration the specified time with a spot position, there is no premature assignment. Out of the money options expire worthless. If an options trader sell a covered call at 1.5500 on the EUR/USD and the price is above 1.5500 at expiration your spot position will be removed from your account and you will keep the premium.
Hedge - The purchase or sale of options or futures contracts as a temporary substitute for a transaction to be made at a later date. Usually it involves opposite positions in the cash, futures or options market. If you buy 1 regular lot of the EUR/USD then 1 put option at 1.5500 you have a perfect hedge or married put.
In-the-money - Option contract that has some intrinsic value. If you buy a put option at 1.5500 and the EUR/USD drops, the put goes into the money.
Intrinsic Value - The difference between the strike price and the underlying fx spot contract rate (American Style Options) or the fx forward rate (European Style Options). The intrinsic value represents the actual value of the option if exercised. Please note that the intrinsic value must be zero (0) or above - if an option has no intrinsic value, then the option is simply referred to as having no (or zero) intrinsic value (the intrinsic value is never represented as a negative number).
If you buy a put option on the EUR/USD at 1.5500 strike price for a premium of $500 this is all time value and no intrinsic value. If the EUR/USD drops 50 pips and the option is worth $1000, $500 is time value and $500 is intrinsic value (in the money amount).
Option Contract - A financial contract giving the buyer the right, but not the obligation, to purchase or sell a specific forex contract (the underlying) at a specific price (the strike price) on or before a specific date (the expiration date). The amount the buyer pays to the seller for the contract rights is called the "premium." This is for someone who buys a put or call.
Option Premium - The amount the buyer pays to the seller for the rights of an option contract.
Out-of-the-money - Option contract having no intrinsic value. EUR/USD trading at 1.5500, buy a put at 1.5500 strike price has no intrinsic value. If the EUR/USD rises above 1.5500 the option is out of the money.
Strike Price – Exercise price.
Uncovered - If you sell a put or call on the EUR/USD with no underlying spot position you are “naked” or uncovered. Don’t do this unless you understand the risk.
In the example above if a currency options trader buys a put on the EUR/USD at a strike price of 1.5500 and the current price is 1.5400 you bought a put in the money since the current market value is below the strike price. If you buy a put on the EUR/USD at a strike price of 1.5500 and the current price is 1.5600 you bought a put out of the money.