Forex Options Overview - An Introduction to Trading...
1 downloads
211 Views
2MB Size
TAKE ME TO SAXO ACADEMY
TRY FREE DEMO
OPEN ACCOUNT
Forex Options Overview - An Introduction to Trading Forex Options Welcome to this introduction to Forex Options trading. Options can be a powerful tool for a trader and you’ll find out how in this module. You’ll be taken through: - - -
An introduction to FX Options How to trade FX Options And the characteristics of FX Options
Please note: Whilst Forex Options isn’t a complicated financial product, if you’re completely new to the concept of Forex trading , we recommend that you take our ‘Introduction to Forex’ course. Hopefully, this module on Options will act as a springboard to further learning and lead to you making smarter, more informed investments. Let’s get started and take a look at the possibilities they might bring to your trading.
TAKE ME TO SAXO ACADEMY
TRY FREE DEMO
Forex Options Overview - An Introduction to Trading Forex Options What do we mean by Forex Options? FX Options may sound like a complex and complicated financial term, but in reality they don’t have to be. FX Options can be a useful addition to any investment strategy, whether it’s a simple directional play – that’s simply a currency pair moving higher or lower - or a large portfolio. FX Options can be used as a direct investment tool for expressing a view in the underlying market, but they can also be applied as a ‘hedging tool’ to be used in conjunction with existing positions. FX Options therefore give investors increased flexibility. This allows you to tailor the risk profile of your positions to match any market view that you might have. You can use FX Options to express a view on a market moving higher, moving lower or even for a market that is moving sideways. FX Options can also be used to express a view on future volatility. For example, if you believe the FX market is about to move, but unsure about the direction, you can structure your portfolio to benefit from a move in either direction. Furthermore, FX Options offer the ability to leverage your positions and therefore significantly increase the potential profits. So, let’s look how FX Options are traded.
OPEN ACCOUNT
TAKE ME TO SAXO ACADEMY
TRY FREE DEMO
OPEN ACCOUNT
Forex Options Overview - An Introduction to Trading Forex Options
Trading FX Options When we trade FX ‘spot’ we buy one currency and simultaneously sell another at whatever the market price is at that time. Spot refers to the current price. If the currency we bought rises in value against the currency we sold, we make money - and conversely, if the value falls, we lose money. An Option, on the other hand, is about trading the currency pair in the future and only if the price is in our favor – at that time. It’s the possibility of trading the currency pair in the future at a predefined price, but is not an obligation to do so. The basic and most common options type is called a ‘vanilla option’. And there are two types of vanilla options – ‘Call’ options and ‘Put’ options. A ‘Call’ option is the right to buy a currency pair at a certain date in the future - referred to as the ‘expiry date’ of the option - and at a certain price. This is known as the ‘strike price’ of the option. Buying a ‘Put’ on the other hand gives you the right to sell the underlying currency pair at the strike price on the expiry date. FX Options are very flexible. You can choose exactly which strike fits your strategy and how long you want the option to last. The combination of different strikes and expiry dates will determine the price, or premium, of the option. In other words, the price you have to pay in order to ‘take’ the Option. So, over the next four pages you’ll look at:
-What a ‘Call’ Option really is…
-An example of a ‘Call’ option in relation to a Euro dollar trade
-How a ‘Put’ option works
-An example of a put option using ozzy dollar as an illustration.
So, let’s explore these new terms.
TAKE ME TO SAXO ACADEMY
TRY FREE DEMO
OPEN ACCOUNT
Forex Options Overview - An Introduction to Trading Forex Options So, What is a Call Option? A Call option is a ‘contract’ which allows the investor to buy a specific amount of the underlying currency pair at the time that the option expires. The maturity of the option and the strike price are predefined and both of these parameters impact on the price. The option to buy the underlying currency pair is exactly what it sounds like… an ‘option’. It is not something you are obliged to do. If the underlying currency pair are trading above the strike price at the end of the option contract, then the investor can use the right and exercise the option to buy the currency pair at the strike price. If the underlying spot price doesn’t reach that level and continues to trade below the strike price, then the investor can simply choose to let the option expire, without doing anything. This basically means that the investor gets the upside potential on a trade without the downside risk.
TAKE ME TO SAXO ACADEMY
Forex Options Overview - An Introduction to Trading Forex Options Call Options – an example. We’re Looking at Euro Dollar spot, currently trading at 1.1000. We expect the currency pair to trade higher over the next two weeks and therefore set a target at 1.1300. To express our market view, we buy a Euro Dollar call option with a strike at 1.1050 and an expiry date in 2 weeks time. The price of the option is 50 pips. So, if we buy this option for a notional value of 10,000 Euro Dollar, then the premium of the option will be: 10,000 x 0.0050 which equals 50 Dollars.
If, after 2 weeks, Euro Dollar is trading below 1.1050, then we will let the option expire. There’s no point in buying Euro Dollar spot at 1.1050 when we can buy it cheaper in the market. The premium we paid for the option will be lost. Notice that the premium is the maximum amount you can lose when buying an option. On the other hand, if Euro Dollar trades above 1.1050 then we should exercise the option, but we need it to trade above 1.1100 to make a profit on the strategy. This is because the price of the option was 50 pips. With Euro Dollar reaching our target at 1.1300 after 2 weeks, we can exercise the option and buy Euro Dollar spot at 1.1050. This will give us a profit of 250 pips on the option, minus the 50 pips we paid in premium, so 200 pips. So, investing in Euro Dollar via FX Options guaranteed a maximum loss of 50 pips, but had a potentially unlimited upside.
TRY FREE DEMO
OPEN ACCOUNT
TAKE ME TO SAXO ACADEMY
TRY FREE DEMO
OPEN ACCOUNT
Forex Options Overview - An Introduction to Trading Forex Options And What is a Put Option? A ‘Put’ option is a contract that allows the investor to sell the underlying currency pair at the strike price when the option expires. So this is the exact opposite of a call option - this is an option to sell the currency pair and not the obligation. Put options can therefore be applied to express the view that a specific currency pair will trade lower. And again, the maximum loss on the option is the premium paid. The potential profit on the other hand is unlimited.Let’s take a look at an example.
TAKE ME TO SAXO ACADEMY
Forex Options Overview - An Introduction to Trading Forex Options Put Options – an example. We think AUSUSD is overvalued and would like to express this in our portfolio. Well, we could sell AUSUSD spot – this means we well at the current market price. The only problem is that it leaves us with open risk on the upside. Most traders have been in a situation where their “stop loss” level has been hit due to temporary volatility, only to see a correction in the market back towards your target. The right view of the market, but a loss instead of a profit. So, instead we buy an Option. AUSUSD is currently trading at 0.7500. We target a move to 0.7000 within 2 months. We buy an AUSUSD put strike 0.7300, expiring in 2 months. The cost is 100 pips. During the 2 months we don’t have to worry about a stop level. At any spot level above 0.7300 we can just let the option expire which leaves without a position. The max loss is capped at 100 pips. Should ozzy dollar reach our target after 2 months, we can then exercise the option and sell at 0.7300. The strategy will earn us 300 pips, minus the 100 pips we paid for the option. The Profit / Loss chart clearly shows the advantages of using FX Option. Max loss is limited, so we don’t need a stop on our position. And at the same time the potential profits are unlimited.
TRY FREE DEMO
OPEN ACCOUNT
TAKE ME TO SAXO ACADEMY
Forex Options Overview - An Introduction to Trading Forex Options Guarantees, Limiting Losses and Leverage… Now we’re going to move on to looking at how Forex Options have some unique characteristics that can benefit traders. -Guaranteed stops and ‘slippage’ -Advantages of using Forex Options to limit losses - and applying leverage to Options Let’s take a look at these in details.
TRY FREE DEMO
OPEN ACCOUNT
TAKE ME TO SAXO ACADEMY
Forex Options Overview - An Introduction to Trading Forex Options Guaranteed Stop The FX market has changed significantly over recent years and liquidity gaps now happen on a more regular basis. This increases the risk of slippage on your stop orders. Slippage is where, due to a lack of liquidity, the stop order gets filled at a worse level than intended. FX Options have the unique characteristic that they give investors full benefits for a move in the right direction, but with only limited risk. FX options are therefore a powerful tool for investments, both as directional plays, but also in combination with an existing FX spot position. On the chart we identify a support line for Sterling Dollar at 1.4000. We buy a spot position at 1.4020 in anticipation that the 1.4000 level will hold, but we place a stop at 1.3985 in case it doesn’t. Unfortunately the support levels eventually broke and the market dropped from 1.4000 down to 1.3900 in one move. As a result the stop order was triggered at 1.3985, but the first tradable price in the market was 1.3900, and this is where the order gets filled. So the max loss on the trade changes from 35 pips to 120 pips, and we are taken out of the position. As an alternative to placing the stop order, we could have bought a Sterling Dollar ‘put’ with a strike at 1.3985 with expiry in 1 week, at a cost of 30 pips. This protects us in case spot trades below 1.3985, and leave a max loss of 35+30 pips. Which equals 65 pips. So even though the maximum loss is higher than we had with the spot strategy, it still has a few benefits.
TRY FREE DEMO
OPEN ACCOUNT
TAKE ME TO SAXO ACADEMY
TRY FREE DEMO
OPEN ACCOUNT
Forex Options Overview - An Introduction to Trading Forex Options Advantages of using FX Options to limit losses So, let’s reviews some of the advantages: - Placing stops in the FX Spot market wont protect you against gaps or drops in the market. - However buying FX Options will provide protection. - With FX Options there is no slippage. We can always sell spot at 1.3985 - Using FX Options as protection, instead of a stop order, also mean that we don’t have to close out the spot position. We can instead keep the long spot position in our book - or portfolio. Should the market move back higher, then we can still benefit and profit from the long spot position. If spot moves all the way to 1.4150, we could earn 130 pips of the Spot position, minus the 30 pips we paid in premium for the option, and in the end book a profit of 100 pips. - The Options will come at a cost, which needs to be added to the maximum potential loss.
Applying Leverage to you position with FX Options, Part 1. Leverage is one of the biggest benefits of trading options. Leverage in financial markets means creating potential for bigger gains whilst risking a smaller amount of your capital. So how do we apply leverage to our strategy? One of the primary factors which determines the cost for buying a particular FX Options is the distance between the chosen strike price and the price of the underlying currency. The further away from the underlying market the strike of the option is, the cheaper the option gets. Choosing a less expensive strike, means that you can increase the notional amount on the option, without increasing the total cost…For example, buying an option on 10,000 Euro Dollar at 30 pips, would cost 30 Dollars or buying an option in 30,000 Euro Dollar at 10 pips would also cost 30 Dollars As investor you can choose many different strikes that will fit your market view, so make sure you explore the opportunities to get the most out of your investments.
TAKE ME TO SAXO ACADEMY
TRY FREE DEMO
OPEN ACCOUNT
Forex Options Overview - An Introduction to Trading Forex Options Applying Leverage to you position with FX Options, part 2 - An Example. So let’s have a look at an example. Euro dollar is currently trading at 1.1000, and we expect a rally to 1.1600 within a month. The maximum potential loss we want to risk on a trade is 15,000 Dollars. So, what’s the best strategy? 1) 2) 3)
Buy Euro dollar spot at 1.1000, stop at 1.0850 in 1million notional Buy Euro dollar call 1.1000, cost 100 pips. in 1.5 million notional. Buy Euro dollar call 1.1250, cost 50 pips. in 3.0 million notional.
The best strategy depends on the target. The advantage of using leverage via FX Options is clearly shown, and if we reach our target at 1.1600 then the profit from the 3 strategies would be 60,000, 75,000 and 90,000. At 1.2000 the profit from the 3 strategies would be 100,000, 135,000 and 210,000. The Options strategy also adds more flexibility to your investments. In this example, where the volatility is rather high, there is also the risk that Euro dollar will trade down to 1.0850, before heading back higher. If that is the case, and spot trades back to 1.1600 at the time of expiry, then the profit / loss on the 3 strategies would look very different because the spot position would have hit the stop level. When you expect increased volatility in the market, investing via FX Options can often turn out to be the optimal solution. Along with the possibility to leverage, you also get protection against temporary moves in the other direction.
TAKE ME TO SAXO ACADEMY
Forex Options Overview - An Introduction to Trading Forex Options Shorting Vanilla Options A long vanilla option will - in most portfolio strategies - be a powerful ally, due to its unique characteristics. But sometimes the premium for buying an option simply seems too expensive in relation to its lifetime or the distance to the underlying market. In such situations the optimal move for your investment could be to sell the option. Let’s take a look at how this works. When you sell an option you no longer have all the benefits. For example, you can no longer choose whether to exercise the option or not. Instead, you have to await the decision from the owner of the option. Should the owner decide to exercise the option, you are then obligated to enter into the transaction. As seller of the option you will initially earn a premium from the option. But, you may also get a liability in the future – should the owner choose to exercise. Let’s look at an example. (See right). Euro dollar is trading at 1.1000, and we sell a ‘1.1200 call option’ at 30 pips, expiring in 1 week. Initially we earn the 30 pips and if Euro dollar trades below 1.1200 when the option expires, then we can keep the 30 pips and the option expires worthless. However, if Euro dollar trades above 1.1200 at expiry time, then the owner of the option will exercise the option and we have the obligation to participate in the trade and offer him to buy Euro dollar from us at 1.1200. So, when shorting vanilla options, the maximum profit is fixed at the premium amount. The potential loss on the other hand is unlimited.
TRY FREE DEMO
OPEN ACCOUNT
TAKE ME TO SAXO ACADEMY
TRY FREE DEMO
OPEN ACCOUNT
Forex Options Overview - An Introduction to Trading Forex Options Short options with existing FX Spot positions Vanilla Options can be put to great use in combination with an existing spot position. The most straightforward approach is to buy an option and use it as a ‘hedge’ against the spot position. However, expressing your view via a spot position without buying protection in form of an option can in many cases be the optimal investment strategy for you - as long as you have an exit strategy in place. In these cases you could actually benefit from selling an option. But this time, selling an option in the same direction as your spot position. So; -Long spot, sell a call -Short spot, sell a put By selling the option you will initially earn a premium. This premium can be used in your strategy as a way to improve your entry on the spot position. If you are long Euro dollar spot from 1.0850, and you choose to sell a 1.1050 Euro dollar call option with the same notional amount as the spot position at a premium of 50 pips, then you can incorporate the 50 pips as part of your stop loss strategy and place your orders 50 pips further away. You use the short option as a ‘take profit’ level for your spot position. You’d choose the strike price of the option to be equal to the target for your spot position. If the options get exercised, you will sell spot at the strike level. So, you made money on the spot move. You made money from selling the option. And you decreased the likelihood of getting stopped out.
TAKE ME TO SAXO ACADEMY
TRY FREE DEMO
Summary So let’s review what we learnt on the course:
3
FX Options may sound like a complex and complicated financial term, but in reality they don’t have to be.
3
An option, on the other hand, is about trading the currency pair in the future and only if the price is in your favor – at that time. It’s the possibility of trading the currency pair in the future at a predefined price, but is not an obligation to do so.
3
You can use FX Options to express a market moving higher, moving lower or even for a market that is moving sideways.
3
FX Options have the unique characteristic that they give investors full benefits for a move in the right direction, but with only limited risk. FX options are therefore a powerful tool for investments, both as directional plays, but also in combination with an existing FX spot position.
3
When you expect increased volatility in the market, investing via FX Options can often turn out to be the optimal solution. Along with the possibility to leverage, you also get protection against temporary moves in the other direction.
3
When you sell an option you no longer have all the benefits. For example, you can no longer choose whether to exercise the option or not. Instead, you have to await the decision from the owner of the option. Should the owner decide to exercise the option, you are then obligated to enter into the transaction.
We hope you enjoyed this course. Please click on any of the live links at the top of this page for more.
OPEN ACCOUNT
