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If you are new to forex options trading, this guide will define what fx options are and explain some of the most basic concepts of forex options trading.
First off, there are two types of options: calls and puts. You can purchase a call or sell a call. The same for puts, you can purchase a put or sell short a put.
- Forex Call Option
When you buy a call option, it gives you the right to buy a given asset at a fixed price (known as the strike price) anytime before a specified expiration date. The option writer (the person who created the option which you purchased), has the legal obligation to sell the asset to you at the strike price, if you exercise the option before the expiration date.
- Forex Put Option
A put option is just the opposite. When you buy a put option, it gives you the right to sell a given asset at the strike price anytime before the expiration date. The option writer, has the legal obligation to buy the asset from you at the strike price, if you exercise the option before it expires.
Underlying
This is the asset, should you decide to exercise the option, in which the option is for.
Why buy forex options?
Two reasons, limited risk and leverage. When you buy an option your risk is limited to the price you pay for the option. And from a leverage standpoint, it allows you to control an expensive asset for a fraction of what it would cost you to purchase the asset outright.
So, if you think that the spread of a specific currency pair is going to increase, you can buy a call option instead of the actual currency pair, or if you feel the price will decrease, you can buy a put option instead of selling the spread.
Most people who trade options lose money.
Why? Because they buy options and that's all they do. They don't take advantage of other option strategies. You should be aware that eighty percent of all options expire worthless. And to make matters worse, the general public buys options without paying attention to the fair value of the option and the implied volatility (all of this is explained later). As a result, they buy overpriced options and often wind up losing money even when they were correct about the price direction!
Options have standardized strike prices and expiration dates.
- Expiration Date
This is the date on which the option expires. For stock options and index options, this is always the Saturday following the third Friday of the expiration month. For example, July 1996 stock & index options will expire on Saturday July 20, 1996. Commodity futures and forex options have their own expiration dates.
- Strike Price
This is the fixed price at which the option can be exercised. It is also known as the exercise price. Options are available for lots of different strike prices for stocks and futures contracts. Your broker will give you a strike price table.
- American Style versus European Style
American style options can be exercised anytime before the expiration date. European style options can only be exercised upon expiration (right before they expire). Most options that trade on exchanges in the United States are American style. One noted exception, however, is the very popular SPX (S&P 500 index option) which trades on the Chicago Board Options Exchange (CBOE) and is a European style option.
- Option Writer
An option writer is any person who writes (creates) an option. When you sell an option that you don't already own, you have just created a new option, and this makes you an option writer.
- In-the-Money
Call options that have a strike price below the current market price of the underlying asset are said to be in-the-money. And likewise, put options that have a strike price which is above the current market price of the underlying asset are in-the-money.
- Out-of-the-Money
This is the opposite of in-the-money. Call options that have a strike price which is above the current market price of the underlying asset are out-of-the-money. Put options that have a strike price which is below the current market price of the underlying asset are out-of-the-money.
- At-the-Money
When an option's strike price is the same as the current market price, the option is at-the-money. Actually, whichever strike price is closest to the market price, is considered to be at-the-money.
- Option Premium
This is the price of the option.
A Forex option’s premium consists of two components:
- Intrinsic Value is the amount that the option is in-the-money. It is the amount that you would receive if you were to exercise the option right now (see "exercising an option" below).
- Time Value is the additional amount that people are willing to pay over and above the intrinsic value. The sum of intrinsic value plus time value equals the option premium. So, if an option's premium is 5.25 and its intrinsic value is 3.00, the time value is 2.25.
Exercising a Forex Option
Owning an option gives you the right to exercise it.
- Call Options
When you exercise a call option, a long position is initiated in the underlining asset at the strike price and you can then sell it at the current market price.
- Put Options
When you exercise a put option, a short position is initiated in the underlining asset at the strike price any you can then cover the position the the current market price.
Remember, when you exercise an option, you only receive the intrinsic value. If the option still has time value, you would be throwing that away. For this reason, you normally don't exercise options that still have time value remaining. In fact, only two percent of all options are ever exercised. Normally, when you buy an option, you will sell it before it expires (and take your profit or loss), or just let it expire worthless.
- Delta
This is the rate of change in an option's price relative to a one unit change in the price of the underlying asset. For example, if a call option has a delta of 0.50 and the price increases by one dollar, the option's price should increase by 50 cents ($1.00 times 0.50).
- Gamma
This is the rate of change of the delta. Let's continue with the example above where a call option has a delta of 0.50. If the call option has a gamma of 0.03 (for instance), it means that the delta will increase from 0.50 up to 0.53 when the price increases by one. It also means the delta will decrease from 0.50 down to 0.47, if the price decreases by one.
- Time Decay
The time value of an option's premium erodes as the option approaches the expiration date. Time decay accelerates and becomes most noticeable during the last month before expiration.
- Theta
This is a measure of the rate of time decay. It is the amount that an option's premium will lose per day due to time decay. It is usually stated in dollars per day.
- Vega
This is a measure of how much an option's premium will increase or decrease due to a change in volatility.
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