Back to School,
Back to Basics.
Discover how to implement our low-risk strategies to generate a second income, or better yet: finding your financial freedom.
Trading foreign exchange, commodity futures, options, previous metals and other over-the-counter or on-exhange products carries a high level of risk and may not be suitable for all investors. This material is meant to be used solely for educational purposes and is not meant to provide trading advice.
TABLE OF CONTENTS
Beginner Level
Chapter 1
- Understanding the basics
- Call & Put Options
- Size Matters – Contract Size
- Long and Short Positions
Chapter 2
- What are Commodities?
- What are the Main Commodities?
- What are the Main Drivers of Commodity Prices?
- How are commodities traded?
- Where can you trade commodities?
Chapter 3
- Risk
- Naked versus covered or hedged short option positions
- Margin trading leverages potential gains-and losses
- When you trade on margin
This course is designed for your educational experience. At the end of each level, we recap important topics with Q&A Level Reviews to help you assess your progress.
Agenda
- Understanding the basics
- Call & Put Options
- Size Matters – Contract Size
- Long and Short Positions
Understanding the basics
What is trading?
Trading involves more frequent transactions, such as the buying and selling of stocks, commodities, currency pairs, or other instruments. The goal is to generate returns that outperform buy-and-hold investing. While investors may be content with annual returns of 10% to 15%, traders might seek a 10% return each month. Trading profits are generated by buying at a lower price and selling at a higher price within a relatevely short period of time.
The reverse also is true: trading profits can be made by selling at a higher price and buying to cover at a lower price (known as “selling short”) to profit in falling markets.
Call & Put Options
The two fundamental types of options are CALLS and PUTS.
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 specified price called the strike price.
- What is the STRIKE PRICE? Strike Price, also known as the “exercise price”, is the stated price at which the buyer of a call has the right to buy a specific currency, or the stated price at which the buyer of a put has the right to sell a specific currency.
Size Matters
Contract size
An option’s size specifies the number of units of currency that one option contract leverages.
Contract sizes are different for options written on different currency pairs.
Long and Short Positions
When you buy options, you create a long position.
When you sell options, you create a short position.
(Selling options is also spoken of as writing options or granting options.)
- 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 are paid for it in the quote currency.
Agenda
- FX Options Expire
- European and American Style Options
- Bid and Ask Prices
- FX Call and Put Contract Specifications
- In the Money, At the Money or Out of the Money
- Intrinsic and Time Value
- Payoffs and Cash Settlements
FX Options Expire
For a fiven 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 expirity months and years.
FX Options expiry are the prerogative of the dealer. Typically, options expire in the third week of the month or the end of the month. Ech dealer handles expiration differently. For the purpose of the Options University, we’ll presume expiration is the third Friday of the expiration month.
Most Dealers Offer FX Options That Are European-style, Not American
Options come in two styles: European style and American style.
European style options can be exercised only at expiration.
American-style options can be exercised at any time up until expiration and at expiration.
The European-American naming convention has nothing to do with geography. You can buy and sell European- and American-style options anywhere in the world.
Most dealers offer FX options that are European style. They can be exercised only at expiration.
Exercising an options means that you take advantage of your right to buy and sell at the strike price. If you exercise a call option, you sell your call option for 0 premium and you go long the spot market at the strike price. If you excercise a put option, you sell your put option for 0 premium and you go short the spot market at the strike price.
An option that has time remaining on the contract may still have some value remaining. When you exercise, you sacrifice any remaining time value on the option to be ling or short in the spot. At expiration, there is no more time value so it’s more common to exercise at expiration — hence this is why most dealers offer European-style options.
More information about the value of options is covered later in this chapter.
Dealers Quote Bid and Ask Prices
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 the quoted price times the contract size then converted into the dealer’s deposit currency such as dollars, euros or yen.
Dealers quote different ask and bid prices.
An ask price is the price at which the dealer will sell an option.
A bid price is the price at which the dealer will buy an option.
At a given moment in time, for a given option, a dealer’s ask price is always higher that their bid price. The bid-ask spread is a main source of dealers compensation.
Some texts use the words dealer and trade interchangeably. Here we use dealer to refer to a market-maker or a direct access entity to the marker in FX options. A dealer is ready, willing and able to be a buyer to all sellers and a seller to all buyers. Dealers quote bid and ask prices. We use trader to mean a price taker. A trader buys options from a dealer at the dealer’s ask price and sells options to a dealer at the dealer’s bid price.
In all financial markets for all financial instruments, the size of a dealer or exchange’s bid-ask spread is the strongest indicator of an instrument’s liquidity. The smaller the bid-ask spread, the grater the liquidity.
FX currency markets have some of the greatest liquidity of any financial markets.
FX Call and Put Contract Specifications
An FX CALL-OPTION contract has these specifications:
- Base/Quote currency pair
- Strike price: The price expressed in the quote currency at which the holder is entitled to buy the base currency from the writer.
- Expiration date.
- Style: European or American.
- Option price or premium to be paid in quote currency.
An FX PUT-OPTION contract has these specification:
- Base/Quote currency pair
- Strike price: The price expressed in the quote currency at which the holder is entitled to sell the base currency to the writer.
- Expiration date.
- Style: European or American.
- Option price or premium to be paid in quote currency.
To incorporate the Base/Quote price-quoting convention into our definitions, 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 mny units of the base currency at a strike price expressed in the qote currency.
In the Money, At the Money or Out of the Money
At a given point in time, a call option is said to be “in the money” if the market price of the base currency is greater than the option’s strike price.
A call option is said to be “at the money” if the price of the base currency is equal to the option’s strike price.
A call is ssaid to be “out of money” if the option’s strike price is greater than the market price of the base currency.
Similarly, at a given point in time, a put option is said to be “in the money” if the market price of the base currency is less than the option’s strike price. A put option is said to be “at the money” if the price of the base currency is equal to the option’s strike price. A put is said to be “out of the money” if the ption’s strike price is less than the market price of the base currency.
Intrinsic and Time Value
At any given point in time, an option’s intrinsic value is the value the option would have if it expired at that moment.
Hence, if an option is in the money, it has a positive intrinsic value.
If an option is at the money or out of the money, then it has an intrinsic value of zero.
An option’s time value is the difference between its market price and is intrinsic value:
Time value = Market price = Intrinsic value
The more time until the expiration date (Days to Expiration is often seen as DTE), then presumably the more expensive the option. If you hold the right to buy something at 1, it would naturally cost more if you could hold onto that right for 1 year rather than 1 month.
The non-intrinsic value is also affected by volatility. If the market place is more volatile, then the chances of its moving up or down (becoming more intrinsic) is increased and thus costs more. Sometimes the Time Value of an option is referred to as Volatility Value even though their theoretical computation is often discussed separately. To most options holders, the two are indistinguishable, so referring to either is typically meaning the same – the non-intrinsic value.
Put and Call Payoffs and Cash Settlements
If at the time a call expires, the Base/Quote spot price is above the option’s strike price, then the opton 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 excercise the option or accept a cash settlement.
If the holder escercises 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, them the holder receives from the writer a cash settlement:
Cash settlement=Payoff x Contract size
Keep in mind that both the spot price and the strike price are expressed in the quote currency.
Cash settlement is in the quote currency and is then converted into the dealer’s deposit currency such as dollars, euro or yen.
Agenda
- FX Options profits and returns
- Risk
- Naked versus covered or hedged short option positions
- Margin trading leverages potential gains– and losses
- When you trade on margin
- Margin requirements for FX options vary
FX Options profits and returns
If an option produces a payoff that is greater than the original cost of the option, then the buyer of the option earns a profit.
If an option expires out of the money and worthless or if the payoff is less than the original cost of the option, then the buyerof the option experiences a loss.
If the payoff equals the original cost of the option exactly, then the buyer of the option breaks even.
The holding-period return on a long position in an option is given by the equation:
HPR=(Payoff-Cost of option)/Cost of option
Risk
The risk of loss that a long position in FX options creates is limited to the value of the options. Limited risk refers to the amount of loss but not the likelihood of loss.
If your options expire worthless, you lose the amount of money that you paid for them.
The risk of loss that a short position creates is quite different.
Selling FX call options creates a risk of loss that is uncapped.
If, for $0.25, you sell the right for the holder to buy a Euro from you at a strike price of $2 and, by the time the call expires, the market price of Euroshas gone to $3, then you’ve lost $1 minus the $0.25 premium you received.
The higher the price of the base currency goes above the strike price, the more money you lose. In theory, when you are short call options, the risk of loss is unlimited.
The risk of loss that a short position in puts creates is ordinarily larger than the amount of premium you receive from the sake, but the risk is capped.
If, for $1, you sell a put that has a strike price of $20 dollars and the price of the underlying drops to $17, then you lose $20 – $0 + $1 = $19 (Values of currencies rarely if ever drop to zero.)
Naked versus covered or hedged short option positions
When you go short calls or puts, you can either take other positions that limit the risk of the short position or not.
If you take other, offsetting or limiting positions, your short position is spoken of as naked.
When you go short call options, you can manage your risk in different ways.
You can buy the underlying currency and sell a like number of call options on it at a strike price at or higher than the price you paid for the currency.
If the currency price goes above the strike price, then you keep the premium you received for the option but forfeit to the call buyer the gain you would have gotten on the rise in value of the currency above the strike price. (Buying the underlying currency to cover the calls you sell limits your risk if the price of the currency rises, but if the currency falls in price, you suffer a loss on the value of the currency you hold.)
Alternatively, to limit your risk when you go short call options at one strike price, you can buy a like number of cheaper call options at a higher strike price. You gain the premium from the sale of the calls at the lower strike price. You pay the lower premium for the calls at the higher strike price. If the price of the currency rises, your net payout on the excerices of the calls you sold is limited to the difference between the two strike prices.
Similarly, when you go short put options, you can take offsetting positions thatlimit or hedge your downside risk.
In theory, when a trader goes short put options, he or she, at the same time, could go short a like amount of the underlying currency. But this is not a good risk-management strategy because, if the value of the currency rises, the trader has unlimited risk of loss from the short sale of the currency.
When going short a put, a more reasonable hedging strategy would be to buy another, cheaper put at a lower strike price. With this hedging strategy, the trader gains the difference between the two premiums. If the currency declines in price, the trader-s payout is limited to the difference between the two strike prices.
Margin trading leverages potential gains- and losses
Most dealers allow traders to trade on margin. That is, they lend you at interest a substantial portion of the money with which to purchase currencies and options.
Dealers may lend you as much as 50:1 on all major pairs and 20:1 on all minor pairs.
In general, buying financial assets on margin allows you to leverage your gains.
If, without margin trading, you paid $100 for a financial asset and the value of the asset then went up in value to $120, you would have a gain of $20. On your $100 investment, you would earn a holding period return of 20%.
If, through margin trading, you acquired a $100 financial asset through a $5 deposit to your margin account and the value of the asset then went up in value to $120, you would have a gain of $20. On your $5 investment, you would earn a holding period return of 400% (less the interest expense).
Trading on margin also leverages your risk exposure. You can lose 100% of your investment. You can lose even more than 100% of your investment.
If, without margin trading, you paid $100 for a financial asset and the value of the asset then went down in value to $95, you would have a loss of $5. On your $100 investment, you would have a holding period return of -5%.
If, through margin trading, you acquired a $100 financial asset through a $5 deposit to your margin account and the value of the assetn then went down in value to $95, you would have a loss of $5. On your $5 investment, you would have a holding period return of -100% (less the interest expense).
If, without margin trading, you paid $100 for a financial asset and the value of the asset then went down in value to $80, you would have a loss of $20. On your $100 investment, you would have a holding period return of -20%.
If, through margin trading, you acquired a $100 for a financial asset and the value of the asset then went down in value to $80, you would have a loss of $20. On your $100 investment, you would have a holding period return of -20%.
If, through margin trading, you acquired a $100 financial asset through a $5 deposit to your margin account and the value of the asset then went down in value o $80, you would have a loss of $20. On your $5 investment, you would have a holding period return of -400% (less the interest expense).
When you trade on margin…
When you trade on margin, then financial assets you hold plus the equity in your margin account serve as collateral for the loan you receive from the dealer. They protec the dealer against losses on the loan.
When a dealer allows a trader to trade on margin, initial- and maintenance- margin requirements ensure that the trader- not the dealer- covers any losses.
In trading financil assets on margin in general, the securities you purchase on margin serve as partial collateral for the loan from the dealer. As additional collateral, a dealer requires that you deposit an initial amount of money into a margin account.