What Is Options Trading?

To fully grasp the concept of time and the value of a year, ask the student who got left back one grade. To understand the value of a month, ask a mother who gave birth to a premature baby. To understand the value of a week, ask any laborer living from paycheck to paycheck. To understand the value of a day, ask the soldier out on leave. To understand the value of an hour, ask the lovers waiting to meet. To understand the value of a minute, ask the commuter who missed the train. To understand the value of a second, ask the motorist who just avoided an accident and to fully understand the value of a split second, ask the athlete who lost a gold medal.   Needless to say, time is also the decisive factor in the investment world. With every tick of the clock fortunes are made and opportunities are lost. In the Foreign Exchange market, where the bulls and bears have little or no role, a timely decision can spell success. Should you buy, sell, hold or trade? What may be profitable for one investor might not necessarily be right for you. An investment plan, tailored to you and not the market, can be the winning edge.

ICC Futures strives to provide the expertise and resources to guide and assist you with all your investment needs in the FXCM market, a unique, exciting and fast moving market. This dynamic environment may furnish the precise opportunities to realize your dreams.

Always bear in mind that all the experience and expertise in the world cannot remove the risk of loss of your investment. It is precisely that risk that gives rise to any profit opportunity. This market may not be suitable for all investors. As in all financial ventures, read the Risk Statements carefully and thoroughly understand it before making your decision.

UNDERSTANDING OPTIONS TRADING:
Options on currencies can offer a wide and diverse range of potentially attractive trading opportunities. However, options trading is a speculative endeavor and should be treated as such. Even though the purchase of options on currencies involves a limited risk (losses are limited to the costs of purchasing the option), it is nonetheless possible to lose your entire investment in a short period of time. And for traders who sell rather than buy options, there is no limit at all to the size of potential losses.

This page is designed to provide you with a basic understanding of options trading on currencies — what they are, how they work and the opportunities (and risks) involved in trading them.

VOCABULARY OF OPTIONS TRADING:

These are just some of the major terms you should familiarize yourself with, starting with what is meant by an “option”.

Option – a trading vehicle which gives the option buyer the right, but not the obligation, to buy or sell a particular currency at a stated price at any time prior to a specified date. There are two separate and distinct types of options: calls and puts.

Call – a call option conveys to the option buyer the right to purchase a particular currency at a stated price at any time during the life of the option.

Put – a put option conveys to the option buyer the right to sell a particular currency at a stated price at any time during the life of the option.

Strike Price – also known as the “exercise price”, this is the stated price at which the buyer of a call has the right to purchase a specific currency or at which the buyer of a put has the right to sell a specific currency.

Underlying Contract - this is the specific currency that the option conveys the right to buy (in the case of a call) or sell (in the case of a put).

Option Buyer – the option buyer is the person who acquires the rights conveyed by the option: the right to purchase the underlying currency if the option is a call or the right to sell the underlying currency if the option is a put.

Option Seller (Writer) – the option seller (also known as the option writer or option grantor) is the party that conveys the option rights to the option buyer.

Premium - the “price” an option buyer pays and an option writer receives is known as the premium. Premiums are arrived at through open competition between buyers and sellers according to the rules of the over-the-counter where the options are traded. A basic knowledge of the factors that influence option premiums is important for anyone considering options trading. The premium cost can significantly affect whether you realize a profit or incur a loss. See “The Arithmetic of Option Premiums” and “Factors that Determine the Option Premium”.

Expiration - this is the last day on which an option can be either exercised or offset. See the definition of “Offset” to be certain you know the exact expiration date of any option you have purchased or written. Options often expire during the month prior to the delivery month of the underlying currency. Once an option has expired, it no longer conveys any rights. It cannot be either exercised or offset. In effect, the option rights cease to exist.

Quotations – most, but not all, currencies are reported daily in the business pages of most major newspapers, as well as by a number of Internet  services.

Exercise – an option can be exercised only by the buyer (holder) of the option at any time up to the expiration date. If and when a call is exercised, the option buyer will acquire a long position in the underlying currency at the option exercise price. The writer of the call to whom the notice of exercise is assigned will acquire a short position in the underlying currency at the option exercise price. If and when a put is exercised, the option buyer will acquire a short position in the underlying currency at the option exercise price. The writer of the put to whom the notice of exercise is assigned will acquire a long position in the underlying currency at the option exercise price.

Offset – an option that has been previously purchased or previously written can generally be liquidated (offset) at any time prior to expiration by making an offsetting sale or purchase. Most options traders choose to realize their profits or limit their losses through an offsetting sale or purchase. When an option is liquidated, no position is acquired in the underlying currency.

Several descriptive terms are used in the options market as a short form for referring to options that have intrinsic value:

In-the-Money – an option is said to be “in-the-money” if it is worthwhile to exercise. A call option is in-the-money if the option exercise price is below the underlying currencies price. A put option is in-the-money if the option exercise price is above the underlying currency price.

At-the-Money – an option is said to be “at-the-money” if the underlying currency price and the option’s exercise price are (approximately) the same

Out-of-the-Money – a call option whose exercise price is above the underlying currency price is said to be “out-of-the-money”. Similarly, a put option is “out-of-the-money” if its exercise price is below the underlying currency price. Neither option is worth exercising, and has no intrinsic value.

Deep-Out-of-the-Money – an out-of-the-money (as described above) option has a strike price which is relatively far from the market price. While no strict definition exists, generally deep-out-of-the-money options can be identified in two ways: 1) the number of strike prices away from the market price, and 2) the value of the premium. An option which is four full strike prices away from the market price, or an option with a value of less than one percent of the value of the underlying currency, may be indications of deep-out-of-the-money options. (However, many exceptions exist.) Such options are considered the most speculative and generally have little likelihood of ever becoming profitable (intrinsic).

Options Trading: Intrinsic and Time Value:

At the time you purchase a particular option, its premium cost may be $1,000. A month or so later, the same option may be worth only $800 or $700 or $600. Or it could be worth $1,200 or $1,300 or $1,400. Since an option is something that most people buy with the intention of eventually liquidating (hopefully at a higher price), it’s important to have at least a basic understanding of the major factors which influence the premium for a particular option at a particular time. There are two, known as intrinsic value and time value. The premium is the sum of these: Premium = Intrinsic Value + Time Value

Intrinsic Value – intrinsic value is the amount of money, if any, that could currently be realized by exercising the option at its strike price and liquidating the acquired currency position at the present price of the currency. At a time when the Japanese Yen is trading at a price of .84 (U.S. cents per 100 yen), a call option conveying the right to purchase the currency at a below-the-market strike price of .83 would have an intrinsic value of $1,250 (a yen option is on 12.5 million yen).

As discussed earlier, an option that currently has intrinsic value is said to be “in-the-money” (by the amount of its intrinsic value). An option that does not currently have intrinsic value is said to be “out-of-the-money”. At a time when the Japanese Yen Treasury is trading at .84, a call option with a strike price of .85 would be “out-of-the-money” and have no intrinsic value.

Time Value – options also have time value. In fact, if a given option has no intrinsic value — because it is currently “out-of-the-money” — its premium will consist entirely of time value.

What’s “time value”? It’s the sum of money option buyers are presently willing to pay (and option sellers are willing to accept) – over and above any intrinsic value the option may have – for the specific rights that a given option conveys. It reflects, in effect, a consensus opinion as to the likelihood of the option’s increasing in value prior to its expiration.

The farther an option’s strike price is from the market price, the less time value it has. Conversely, options which are deep-in-the-money have little time value. The time value of an option is always highest when it is at-the-money.

The three principal factors that affect an option’s time value are (this description ignores interest rates):

1. Time Remaining Until Expiration
Time value declines as the option approaches expiration. At expiration, it will no longer have any time value. (This is why an option is said to be a wasting asset.)
Time Value of an Option Under Passage of Time

2. Relationship Between the Option Strike Price and the Current Price of the Underlying Currency
The further an option is removed from being worthwhile to exercise the further “out-of-the-money” it is the less time value it is likely to have.

3. Volatility
The more volatile a market is, the more likely it is that a price change may eventually make the option worthwhile to exercise. Thus, the option’s time value, and therefore premiums, are generally higher in volatile markets. Volatility, mathematically expressed, is the standard deviation of price movements of some period of time. However, as you can see, volatility is the “soft” number of the three factors discussed here; in other words, the other two factors are objective values, only volatility is subjective. As a consequence, there are many ways of calculating and interpreting volatility. Using the market price of option premiums to “back into” the volatility. This calculation derives what is known as “implied volatility”.

SOME OPTIONS TRADING MYTHS:

Many people have been misinformed about options trading and this has led to unrealistic expectations. Unfortunately, this has often led to significant losses in the markets. The marketing hype is simply that, but that doesn’t mean you cannot succeed in options trading. Let’s debunk some myths:

Myth: You should place low risk/reward trades only where you are risking $1 to make $3.

-But the probability of earning that $3 profit is very low. Over time the losses will overwhelm your infrequent gains.

Myth: A far out-of-the-money (OTM) bull call spread is a low risk trade because you are risking only $1.

-Only $1 is at risk, but the probability of losing that $1 is quite high. This is the options equivalent of the lottery ticket.

Myth: If I position an iron condor trade with an 85% probability of success, I will make a profit 10 months out of the year, have only two losing months, and therefore be profitable for the year.

-A high probability of success comes with a high risk/reward ratio, therefore, the losses of those two losing months will wipe out the year’s gains.

Myth: I always trade deep in-the-money (ITM) bull call spreads where I am making  only 10% profit but I have a 90% probability of success. This is a conservative strategy that always makes money.

-Again, a high probability of success comes with a high risk/reward ration; losses will be infrequent but large. Over time , the net returns will tend toward zero.

Myth: One should only sell options because most options expire worthless.

-The probability of the option’s expiring worthless is built into the option’s price. There is no inherent advantage to taking either side of this trade.

Myth: One should only buy options because he has limited downside risk.

-The probability of a long option’s ultimately being profitable is built into the option’s price, and, therefore, there is no inherent advantage to taking either side of this trade.

One of the most important lessons of applying probability distribution calculations to your trading is to debunk the common marketing hype of options trading, namely, that the iron condor or brokenwing butterfly or whatever is the best trading strategy. The harsh reality is that the is no such thing as “best options strategy.” The risk-adjusted return of any options stratefy will tend toward zero over time.

Understanding the probabilities underlying your trade enables you to predict the expected pattern of results of gains and losses. A robust risk management system is critical for the long-term success and profitability of any options trading strategy.

The range and complexity of options trading strategies are practically limitless. Browse our site to learn more about options trading.