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How To Use FX Options In Forex Trading.

Foreign exchange options are a relative unknown in the retail currency world. Although some brokers offer this alternative to spot trading, most don't. Unfortunately, this means investors are missing out. (For a primer on FX options, see Getting Started in Forex Options .)

FX options can be a great way to diversify and even hedge an investor's spot position. Or, they can also be used to speculate on long - or short-term market views rather than trading in the currency spot market.

So, how is this done?

Structuring trades in currency options is actually very similar to doing so in equity options. Putting aside complicated models and math, let's take a look at some basic FX option setups that are used by both novice and experienced traders.

Basic options strategies always start with plain vanilla options. This strategy is the easiest and simplest trade, with the trader buying an outright call or put option in order to express a directional view of the exchange rate.

Placing an outright or naked option position is one of the easiest strategies when it comes to FX options.

Basic Use of a Currency Option.

ISE Options Ticker Symbol: AUM.

Spot Rate: 1.0186.

Long Position (buying an in the money put option): 1 contract February 1.0200 120 pips.

Maximum Loss: Premium of 120 pips.

Profit potential for this trade is infinite. But in this case, the trade should be set to exit at 0.9950 – the next major support barrier for a maximum profit of 250 pips.

The Debit Spread Trade.

The first of these spread trades is the debit spread, also known as the bull call or bear put. Here, the trader is confident of the exchange rate's direction, but wants to play it a bit safer (with a little less risk).

In Figure 2, we see an 81.65 support level emerging in the USD/JPY exchange rate in the beginning of March 2011.

This is a perfect opportunity to place a bull call spread because the price level will likely find some support and climb. Implementing a bull call debit spread would look something like this:

ISE Options Ticker Symbol: YUK.

Long Position (buying an in the money call option): 1 contract March 81.50 183 pips.

Short Position (selling an out of the money call option): 1 contract March 82.50 135 pips.

Net Debit: -183+135 = -48 pips (the maximum loss)

Gross Profit Potential: (82.50 - 81.50) x 10,000 (units per contract) x 0.01 pip = 100 pips.

If the USD/JPY currency exchange rate crosses 82.50, the trade stands to profit by 52 pips (100 pips – 48 pips (net debit) = 52 pips)

The Credit Spread Trade.

Now, let's refer back to our USD/JPY exchange rate example.

With support at 81.65 and a bullish opinion of the U. S. dollar against the Japanese yen, a trader can implement a bull put strategy in order to capture any upside potential in the currency pair. So, the trade would be broken down like this:

ISE Options Ticker Symbol: YUK.

Short Position (selling in the money put option): 1 contract March 82.50 143 pips.

Long Position (buying an out of the money put option): 1 contract March 80.50 7 pips.

Net Credit: 143 - 7 = 136 pips (the maximum gain)

Potential Loss: (82.50 – 80.50) x 10,000 (units per contract) x 0.01 pip = 200 pips.

200 pips – 136 pips (net credit) = 64 pips (maximum loss)

As anyone can see, it's a great strategy to implement when a trader is bullish in a bear market. Not only is the trader gaining from the option premium, but he or she is also avoiding the use of any real cash to implement it.

Both sets of strategies are great for directional plays. (For more on directional plays, see Trade Forex With A Directional Strategy .)

The straddle is a bit simpler to set up compared to credit or debit spread trades. In a straddle, the trader knows that a breakout is imminent, but the direction is unclear. In this case, it's best to buy both a call and a put in order to capture the breakout.

Figure 3 exhibits a great straddle opportunity.

In Figure 3, the USD/JPY exchange rate dropped to just below 82.00 in February and remained in a 50-pip range for the next couple of sessions. Will the spot rate continue lower? Or is this consolidation coming before a move higher? Since we don't know, the best bet would be to apply a straddle similar to the one below:

ISE Options Ticker Symbol: YUK.

Long Position (buying at the money put option): 1 contract March 82 45 pips.

Long Position (buying at the money call option): 1 contract March 82 50 pips.

It is very important that the strike price and expiration are the same. If they are different, this could increase the cost of the trade and decrease the likelihood of a profitable setup.

Net Debit: 95 pips (also the maximum loss)

The potential profit is infinite – similar to the vanilla option. The difference is that one of the options will expire worthless, while the other can be traded for a profit. In our example, the put option expires worthless (-45 pips), while our call option increases in value as the spot rate rises to just under 83.50 – giving us a net 55 pip profit (150 pip profit – 95 pip option premiums = 55 pips).

Option Premium.

What is an 'Option Premium'

An option premium is the income received by an investor who sells or "writes" an option contract to another party. An option premium may also refer to the current price of any specific option contract that has yet to expire. For stock options, the premium is quoted as a dollar amount per share, and most contracts represent the commitment of 100 shares.

BREAKING DOWN 'Option Premium'

Option prices quoted on an exchange such as the Chicago Board Options Exchange (CBOE) are considered premiums as a rule, because the options themselves have no underlying value. The components of an option premium include its intrinsic value, its time value and the implied volatility of the underlying asset. As the option nears its expiration date, the time value will edge closer and closer to $0, while the intrinsic value will closely represent the difference between the underlying security's price and the strike price of the contract.

Factors Affecting Option Premium.

The main factors affecting an option's price are the underlying security's price, moneyness, useful life of the option and implied volatility. As the price of the underlying security changes, the option premium changes. As the underlying security's price increases, the premium of a call option increases, but the premium of a put option decreases. As the underlying security's price decreases, the premium of a put option increases, and the opposite is true for call options.

The moneyness affects the option's premium because it indicates how far away the underlying security price is from the specified strike price. As an option becomes further in-the-money, the option's premium normally increases. Conversely, the option premium decreases as the option becomes further out-of-the-money. For example, as an option becomes further out-of-the-money, the option premium loses intrinsic value, and the value stems primarily from the time value.

The time until expiration, or the useful life, affects the time value, or extrinsic value, portion of the option's premium. As the option approaches its expiration date, the option's premium stems mainly from the intrinsic value. For example, deep out-of-the-money options that are expiring in one trading day would normally be worth $0, or very close to $0.

Implied Volatility.

Implied volatility is derived from the option's price, which is plugged into an option's pricing model to indicate how volatile a stock's price may be in the future. Moreover, it affects the extrinsic value portion of option premiums. If investors are long options, an increase in implied volatility would add to the value. The opposite is true if implied volatility decreases. For example, assume an investor is long one call option with an annualized implied volatility of 20%. Therefore, if the implied volatility increases to 50% during the option's life, the call option premium would appreciate in value.

Pricing.

Vanilla Options.

Saxo’s FX Vanilla option offering provides the possibility to both buy and sell European style options, giving clients the opportunity to express a directional view in two different ways. FX options not only enable clients to express a directional trading view but also offer more alternatives in relation to controlling risk, in addition to a traditional stop loss order.

The holder of an option (long) pays a premium for the right to exercise the option at a profit, or let the option expire with no further obligation. The writer of an option (short) receives the premium and assumes the possible liability of having to pay the difference between the strike price and market price at maturity.

The pricing model Saxo Bank applies for FX Vanilla options is based on an implied volatility surface for the Black-Scholes model. The price is calculated in pip terms of the 2nd currency. Pricing is available for options with maturities from 1 day to 12 months, providing you with maximum flexibility to implement your trading strategies and market views.

The spread is defined as the distance between the bid/ask price. Spreads may vary depending on the life of the option and the currency pair.

Maximum streaming notional amount is 25 million units of base currency; with a minimum ticket size of 10,000 on currency pairs; and for precious metals 10 oz (Gold) and 100 oz (Silver).

Notional amounts over maximum streaming amount are request for quote (RFQ).

Small trade sizes incur a minimum ticket fee of 10 USD. A small trade size is any trade below the commission threshold which for most currency pairs is 50,000 units of base currency, however variations occur. Full details can be found here.

Touch Options.

Saxo’s FX Touch option offering provides the possibility to both buy and sell One Touch and No Touch options, giving clients the opportunity to express a directional view in two different ways.

The maximum streaming amount is 25,000 units of base currency, with a minimum ticket size of 100 units. Notional amounts above the maximum streaming amount are available on a R equest for Quote (RFQ) basis. Tradable tenors from 1 day to 12 months.

The price of a Touch option is called the Premium and is expressed as a percentage of the potential payout. For instance, for a notional size of 1,000 and a price of 10%, the Premium will be 100 units of base currency and the Payout will be 1,000 units of base currency. For long positions you pay the premium and for short positions you receive the premium.

You are looking for a potential payout of EUR 1,000 if EURUSD touches 1.1500 within two weeks. The premium of the One Touch option is 20%.

You pay EUR 200 (EUR 1,000 x 20%) for the option.

If the EURUSD spot price touches 1.1500 before it expires you receive the pay-out of EUR 1,000 (net profit of EUR 800).

If it doesn't reach the trigger level of 1.1500 your loss on the trade is the initial premium you paid for the option (EUR 200).

At Saxo Bank FX Touch options can be either bought or sold.

An option is categorised as a red product as it is considered an investment product with a high complexity and a high risk.

You should be aware that in purchasing Foreign Exchange Options, your potential loss will be the amount of the premium paid for the option, plus any fees or transaction charges that are applicable, should the option not achieve its strike price on the expiry date.

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The Price of an Option: The Option Premium.

International Finance For Dummies.

The option premium (hereafter, the premium) is also called as the price of an option. The buyer of the call or put option has the right but not obligation to buy or sell currency, respectively. Therefore, the premium is the price of having a choice.

In fact, for both types of options, call or put options, the premium is paid at the time of buying these options (actually agreed to be paid, because it’s credited or debited two working days following obtaining an options contract.) The premium is expressed in dollars per unit of currency.

Now you know why the premium is called the option price: you pay the premium upfront when you get a call or put option. You can look at the premium as a sunk cost (a cost that already incurred and cannot be recovered), especially when exercising or not exercising your right to buy or sell currency.

However, as some of the upcoming numerical exercises will show that, especially in speculation, the premium is not a sunk cost when it comes to calculating your profit or payoff.

When you look at the financial media, such as the Wall Street Journal, you’ll see that the premium is expressed in so-called pips . (In finance, a pip is 1/100th of one percent.) When you read about, for example, the premium of a call option being 3.94 per euro on the dollar-euro exchange rate, it means that you have to pay for each euro $0.0394 as a premium.

Option premiums aren’t the same for all currencies or maturities. The valuation of an option is mathematically complex. A number of variables, such as the forward rate, the current spot rate, the strike price, the time to maturity, the volatility of currencies, and the home and foreign interest rates are included in the valuation of foreign exchange options.

The table summarizes the characteristics of foreign exchange options. The buyer or the holder of a call or put option pays the premium for having a choice between exercising and not exercising the option.

While the seller or the writer of a call or put option receives and keeps the premium, he has obligations toward the buyer of the option, if the buyer decides to exercise the option.

In the case of a call option, these obligations imply that, once the buyer decides to exercise the option, the writer has to sell to the buyer of the call option a specified amount of currency at the specified strike price.

In the case of a put option, once the buyer decides to exercise the option, the writer has to buy from the buyer of the put option a specified amount of currency at the specified strike price.