Forex Options
Forex options are the next frontier in forex trading.
Forex options give you just what their name suggests:
options in your forex trading. If you have been looking
for a way to add unparalleled flexibility to your trading,
you have come to right place. Saxo Bank has the most
comprehensive forex option trading platform in the industry.
Come see what you have been missing by simply buying and selling currency pairs.
Forex options allow you to not only take advantage of movement in a currency
pair but also limit the risk you expose your account to. You can make money
with options when currency pairs are moving higher, when currency pairs are
moving lower and even when currency pairs are moving sideways.
We will begin with standard options in this section to lay a solid foundation
to get you started in your option trading. Standard options are also called
vanilla options because they are plain and simple - they don't have a lot
of extra frills. In subsequent sections, we will discuss exotic options - options
with extra frills that you can apply in unique situations.
In this options section, we will explain the following to get you ready to place your first option trade:
Vanilla Options - Calls and Puts
Vanilla options come in two varieties: calls and puts. Call options
give you the right, but not the obligation, to buy a currency pair
at a certain price on or before a certain date. Put options give
you the right, but not the obligation, to sell a currency pair at
a certain price on or before a certain date.
You have the ability to 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 take advantage of the upward
movement of the currency pair. If you believe a currency pair is going
to move lower, you can either buy a put option or sell a call option
to take advantage of the downward movement of the currency pair.
You will learn more about what you can do with options later in this
section when we discuss what type of an option trader you will be.
Right now it is important for you to learn the basics of what options
are and how they work so you can use them appropriately in your forex
trading. Take a moment to become familiar with the following:
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Option Characteristics |
Forex options are unique, multi-dimensional trading tools. They
give you tremendous flexibility in your investing. If you want
to successfully use them in your own portfolio, however, you need
to become familiar with their distinctive traits.
Every vanilla option has the following three characteristics:
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 you can sell a currency pair (if you have
bought a put option or sold a call option).
Expiry date: this is the date on which the option
expires, or becomes worthless, if nobody exercises it.
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 on December 21.
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The Value of an Option |
The value of an option has two elements: intrinsic value and time value.
Intrinsic value - Market convention is to refer to
the price of the underlying asset minus the strike of the option as the option's
intrinsic value (for a Call option, for a Put it is just the opposite).
Theoretically, one could argue that the forward rate of the underlying
asset should be used instead of its spot, but market convention is to use the spot.
Time value - Simply put, 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 increases as volatility increases
because of the Profit/Loss scenario for an option. As previously mentioned,
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 on a less volatile asset.
Interest rates differentials in the two currencies involved in a currency
option trade must also be taken into consideration when pricing an option,
and these are also a function of time.
This graph depicts how a call option is priced according to how close the
asset price is to the strike price for the option.
Let's say that 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 thirty days before the option's expiration date.
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 case 70 pips).
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Option Greeks |
Option prices are affected by five factors, each of which has a
Greek name to represent it. As you progress as a forex option
trader, you will see the following options Greeks on a regular basis:
- Delta
- Gamma
- Theta
- Vega
- Rho
Delta - Describes how the value of an option changes
as a result of small changes in the underlying asset, assuming that all
the other factors influencing option pricing are constant. The delta of
an option can also be viewed 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 - Describes how the delta of the option changes
when the underlying asset changes. Hence, the gamma also describes how you
should 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 provides insight into the investor's view on the
volatility of the underlying asset, as a long position shows expectations
of a volatile market while a short position indicates that he/she expects a calm market.
Theta - Describes the change in the value
of the option when time passes and everything else remains
constant. This change stems from the fact that the time to
an option's expiration is reduced with the passage of time.
This change in value is also commonly referred to as how much
the option 'bleeds' the speculator. The theta (sensitivity) is
often noted in pips lost in value per day that passes.
Vega - Describes the change in the value of the
option when the volatility changes. The volatility represents how
large the swings are in the underlying asset and is the cornerstone
in option pricing. Larger swings imply that the underlying asset is
more likely to take on more extreme values. While the option holder's
risk is limited to the premium, his/her upside is unlimited for vanilla
options. Hence, an increase in the volatility of the underlying asset
increases the value of the option. As the table below suggests, the
sensitivity is larger the closer to At-The Money (ATM)* the option
is and the longer it has until it expires.
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 does not include 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).
*At-the-money means that the strike price is the same as the current
price of the currency pair when you enter the trade.
Option Buyers and Option Sellers
Forex option traders can be either 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 traders who enter
a trade by selling either a call or a put option. Your decision to
buy an option contract or to sell an option contract will be based
on whether you are bullish or bearish on a currency pair.
You can make money with forex options whether currency pairs
are going up, down or sideways.
Up - If your fundamental and technical analysis
tells you that the currency pair is going to be moving up, you can
either buy a call option or sell a put option.
Down - If your fundamental and technical analysis
tells you that the currency pair is going to be moving down, you
can either buy a put option or sell a call option.
Sideways - If your fundamental and technical
analysis tells you that the currency pair is going to be moving
sideways, you can either sell a call option or sell a put option.
| | CALL | PUT |
| UP | BUY | SELL |
| DOWN | SELL | BUY |
| SIDEWAYS | SELL | SELL |
Buying a call or a put option allows you to take advantage of virtually
unlimited profits so long as the currency pair continues moving higher
if you bought a call option or lower if you bought a put option.
However, the currency pair does have to move far enough to overcome
the initial premium you paid for the option.
Selling a call or a put option allows you to collect your profits
up front and keep the full profit so long as the currency pair remains
below the strike price of the call you have sold or above the
strike price of the put you have sold. However, if the currency
pair does move past your strike price, you can lose more money that
you collected by selling the option.
Let's take a look at how each of the following option trades reacts
in various market conditions (assuming you buy or sell ATM options):
Before you look at how these option trades will react, however, you need to
acquaint yourself with the tool we will be using to illustrate the affect
various market conditions will have on your option trades: a risk graph.
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Buying a Call Option |
Buying a call option, or going long the call option, is a bullish option trade - which means
you want the underlying currency pair to go up in value. If the currency pair goes up,
you will maximize your profits on your call trade.
Unfortunately currency pairs don't always do what you want them to do in
the forex market, and you need to know what will happen to your call option
in various scenarios. A currency pair can do one of the following five things:
- Go up a lot
- Go up a little
- Remain flat
- Go down a little
- Go down a lot
Up a Lot - When you have bought a call and the currency pair
moves up a lot, you maximize your profits on the trade. Every pip higher the
currency pair moves 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 crosses the breakeven point.
(To learn more about risk graphs, like the one above, click here)
Up a Little - When you have bought a call and the currency
pair moves up a little, you minimize your losses on the trade. Every pip
higher the currency pair moves above the strike price for the call option
reduces your losses. You can see how the blue profit/loss line starts to
rise after it crosses the strike price level but that it is still below breakeven.
(To learn more about risk graphs, like the one above, click here)
Flat - When you have bought a call and the currency pair
remains 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.
(To learn more about risk graphs, like the one above, click here)
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.
(To learn more about risk graphs, like the one above, click here)
Down a lot - When you have bought a call and the currency pair
goes 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.
(To learn more about risk graphs, like the one above, click here)
In review, here are the results you can expect from different price action when you buy a call option.
| PRICE ACTION | RESULT |
| Up a Lot | Maximize Gains |
| Up a Little | Minimize Losses |
| Flat | Achieve Maximum Loss |
| Down a Little | Achieve Maximum Loss |
| Down a Lot | Achieve Maximum Loss |
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Buying a Put Option |
Buying a put option, or going long the put option,
is a bearish option trade - which means you want the underlying
currency pair to go down in value. If the currency pair goes down,
you will maximize your profits on your put trade.
Unfortunately currency pairs don't always do what you want them
to do in the forex market, and you need to know what will happen
to your put option in various scenarios. A currency pair
can do one of the following five things:
- Go up a lot
- Go up a little
- Remain flat
- Go down a little
- Go down a lot
Up a Lot - When you have bought a put and the
currency pair moves 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, you lose the entire premium
(your maximum loss). You can see how the blue profit/loss line
remains flat at its lowest level above the strike price.
(To learn more about risk graphs, like the one above, click here)
Up a Little - When you have bought a put and the
currency pair moves up 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 goes up 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.
(To learn more about risk graphs, like the one above, click here)
Flat - When you have bought a put
and the currency pair remains flat, 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 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.
(To learn more about risk graphs, like the one above, click here)
Down a little - When you have bought a
put and the currency pair goes down a little, you
minimize your losses on the trade. Every pip lower
the currency pair moves below the strike price for the
put option reduces your losses. 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.
(To learn more about risk graphs, like the one above, click here)
Down a lot - When you have bought a
put and the currency pair goes down a lot, you maximize
your profits on the trade. Every pip lower the currency
pair moves below the breakeven point for the put option
makes you more money. You can see how the blue profit/loss
line continues to rise after it crosses below the breakeven point.
(To learn more about risk graphs, like the one above, click here)
In review, here are the results you can expect from different price action when you buy a put option.
| PRICE ACTION | RESULT |
| Up a Lot | Achieve Maximum Loss |
| Up a Little | Achieve Maximum Loss |
| Flat | Achieve Maximum Loss |
| Down a Little | Minimize Losses |
| Down a Lot | Maximize Gains |
|
Selling a Call Option |
Selling a call option, or going short the call option,
is a bearish option trade - which means you want the
underlying currency pair to go down in value. If the currency
pair goes down, you will maximize your profits on your call trade.
Unfortunately currency pairs don't always do what you want
them to do in the forex market, and you need to know what
will happen to your call option in various scenarios.
A currency pair can do one of the following five things:
- Go up a lot
- Go up a little
- Remain flat
- Go down a little
- Go down a lot
Up a Lot - When you have sold a call and
the currency pair moves up a lot, you maximize your
losses on the trade. Every pip higher the currency pair
moves above the breakeven point for the call option costs
you more money. You can see how the blue profit/loss line
continues to fall after it crosses the breakeven point.
(To learn more about risk graphs, like the one above, click here)
Up a Little - When you have sold a call
and the currency pair moves up a little, you minimize
your gains on the trade. Every pip higher the currency
pair moves above the strike price for the call option
reduces your gains. 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.
(To learn more about risk graphs, like the one above, click here)
Flat - When you have sold a call and the currency
pair remains flat, you reach the maximum gain on the trade.
When you sell a call option, you receive the premium up front.
If the currency pair remains 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.
(To learn more about risk graphs, like the one above, click here)
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 receive
the premium up front. If the currency pair goes down a little,
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.
(To learn more about risk graphs, like the one above, click here)
Down a lot - When you have sold a call and
the currency pair goes down a lot, you reach the maximum gain
on the trade. When you sell a call option, you receive the
premium up front. If the currency pair goes 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.
(To learn more about risk graphs, like the one above, click here)
In review, here are the results you can expect from different price action when you buy a call option.
| PRICE ACTION | RESULT |
| Up a Lot | Maximize Losses |
| Up a Little | Minimize Losses |
| Flat | Achieve Maximum Gain |
| Down a Little | Achieve Maximum Gain |
| Down a Lot | Achieve Maximum Gain |
|
Selling a Put Option |
Selling a put option, or going short the put option, is a bullish
option trade - which means you want the underlying currency pair to
go down up value. If the currency pair goes up, you will maximize
your profits on your put trade.
Unfortunately currency pairs don't always do what you want them
to do in the forex market, and you need to know what will happen
to your call option in various scenarios. A currency pair can
do one of the following five things:
- Go up a lot
- Go up a little
- Remain flat
- Go down a little
- Go down a lot
Up a Lot - When you have sold a put and the
currency pair moves up a lot, you reach the maximum gain on
the trade. When you sell a put option, you receive the premium
up front. If the currency pair goes up 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 above the strike price.
(To learn more about risk graphs, like the one above, click here)
Up a Little - When you have sold a put
and the currency pair moves up a little, you reach the
maximum gain on the trade. When you sell a put option, you
receive the premium up front. If the currency pair goes up
a little, 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 above the strike price.
(To learn more about risk graphs, like the one above, click here)
Flat - When you have sold a put and the
currency pair remains flat, you reach the maximum gain on
the trade. When you sell a put option, you receive the
premium up front. If the currency pair remains 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.
(To learn more about risk graphs, like the one above, click here)
Down a little - When you have sold a
put and the currency pair goes down a little, you
minimize your gains on the trade. Every pip lower
the currency pair moves below the strike price for
the put option reduces your gains. 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.
(To learn more about risk graphs, like the one above, click here)
Down a lot - When you have sold a
put and the currency pair goes down a lot, you maximize
your losses on the trade. Every pip lower the currency
pair moves below the breakeven point for the put option
costs you more money. You can see how the blue profit/loss
line continues to fall after it crosses the breakeven point.
(To learn more about risk graphs, like the one above, click here)
In review, here are the results you can expect from different price action when you buy a call option.
| PRICE ACTION | RESULT |
| Up a Lot | Achieve Maximum Gain |
| Up a Little | Achieve Maximum Gain |
| Flat | Achieve Maximum Gain |
| Down a Little | Minimize Losses |
| Down a Lot | Maximize Losses |
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Reading a Risk Graph |
Risk graphs are a simple tool you can use to visualize what the
result of your option trade will be in various market situations.
Risk graphs illustrate what the result of your option trade will
be if the currency pair does any of the following:
- Go up a lot
- Go up a little
- Remain flat
- Go down a little
- Go down a lot
As you look at a risk graph, you will see the following
components (we will use a risk graph for a long call to illustrate):
Profit/Loss axis - the vertical axis on the left
of the chart that shows the profit/loss you will receive. For example,
Point C shows a profit along the profit/loss axis, while Point D
shows a loss along the profit/loss axis.
Currency price axis - the horizontal axis that runs
through the middle of the chart represents the price of the currency pair.
Prices run lower to higher from left to right. For example, Point C is at a higher price than Point D.
Profit/Loss line - the blue line that runs
through the chart shows the profit/loss you will receive at
any given price along the chart. For example, Point C shows you
will receive a profit when the currency pair is at a higher price,
while Point D shows you will receive a loss when the currency pair is at a lower price.
Strike price - the price at which the option
holder can exercise an option. The strike price is represented
by Point A on the chart. Remember, calls become profitable
above the strike price while puts become profitable below the strike price.
Breakeven point - the point at which you
neither make money nor lose money on your option trade.
The breakeven point is represented by Point B on the chart.
Remember, the breakeven point for calls is always above
the strike price while the breakeven point for puts is always below the strike price.
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