Tag: Education

Forex Options VI – Assessing options

Probabilities

If you’ve been following our Options video series, you’ve understood that options trading is a game of chance. Thus, if you hope to succeed at trading options, you must strive to consistently place the odds in your favor as much as you can on every trade you intend to make.
Options traders must realize that options are not the same as trading the underlying asset. Options have a time premium that vanishes with time, and that makes their probability of profit to be less than 50%.

Pros and Cons

Although forex traders are used to having an opinion on whether a pair is going to move up or down, the options’ trader should not theorize about it, but comparing the risk and reward characteristics of several possible trades to decide which is the most desirable. Dreaming about unlimited profits while buying low-probability options or selling far out of the money options with high-probability of profits without minimizing the risk is a recipe for disaster.

The Delta as a proxy of probability

An option’s Delta can be determined for each option, using an option-pricing model, which usually is made available by the broker to its customers. Sites such as Investing.com display the Delta of the most usual FX options.
Delta values range from 0 to 100 on Calls and from -100 to 0 on Puts. Delta can be viewed as
1.- An estimate of the odds that the option will be in the money at its expiry. For instance, if the EURUSD 1.1650 Sept Call has a delta of 0.33, it has about a 33% probability of expiring in the money.

2.- A delta of 0.33 implies that the option moves 0.33 pips for every pip of movement on the underlying. A delta of 100 means the option position is equivalent to buying the underlying asset; thus, a delta of -50 is equal to being short the underlying with half of the original position size.

Please note, though, that the Delta of an option changes with time and price movements.

Delta Neutral

Delta neutral is a way to place the overall trade position so that the Delta nears to zero. This can be achieved by having a combination of options with positive and negative deltas so that their summation is near zero. Delta neutral traders don’t bother with market movements, because they don’t not affect them. Their task is to keep their position neutral, rebalancing it when the position moves away from neutral by opening new positions and/or closing open ones. According to advocates of this methodology, Delta Neutral strategies naturally make a trader buy low and sell high, creating a consistently profitable game.

Probability and risk Analysis

Options traders usually have several ways to fill an options trade for a determined strategy. Thus, evaluating the probability and the risk of the possible trade combinations will determine which is the most profitable and best candidate.
For example, a trader may be decided to buy a put and a call on the EURUSD pair before a potential disrupting event. That way, he will profit from the volatility raise without caring about direction. But he may be in doubt about whether to buy them at the same strike price (Straddle) or a different price (Strangle).

The trader must consider the following for every candidate combination:

• Upside and downside break-even points
• Probability of being outside of BE at Expiration
• Profit at expiration for the upward and downward targets
• The maximum loss of the option combination
• Likelihood of experiencing the maximum loss.

A table made with these parameters will show the best alternative, which in this case, is the Straddle, as it shows the best settings and also the highest rewards for its risk.

Keys to Success in Option Trading

The essential trading guidelines to succeed in options trading are:

• Identifying the strategies available
• Understanding when to use a given plan to maximize the benefit
• Accurately evaluating the level of the current volatility
• Identifying whether it is time is to buy premium or sell premium
• Buying undervalued options and selling overvalued options
• Recognizing when there are disparities in the implied volatilities of different options and take advantage of the fact
• Properly take a profit and cut a loss

Stay tuned for more on Option Strategies!

Recommended reading:
THE OPTION TRADER’S GUIDE TO PROBABILITY, VOLATILITY, AND TIMING , by Jay Kaeppel

Forex Options III- Risk Profiles of the Basic PUT/CALL Strategies

A Risk profile is the most important tool for analyzing the gain-loss potential of an Options strategy. Thus we need to dedicate a chapter to understand how to make risk profiles. That is because understanding and managing risk is a critical task for the options trader.

Risk profile

A risk profile is the graphical representation of the profit-loss of an options trade in relation to the changes in the price of the underlying asset. The horizontal axis shows the possible stock prices of the underlying asset. The vertical axis from bottom to top show potential losses and profits. The graph lines indicted the theoretical profit and loss of a position at expiration. The zero-line is the trader’s break-even point.

To create a risk profile of a Call option, the horizontal line below the zero-line would represent the cost of the option at day zero. Since below the strike price, the option has no intrinsic value. The horizontal line shows its time value. This line is extended until the strike price point. From there, profits begin to add up, so the path heads to the upside with a slope that reflects the profit and price change.

EURUSD 1.1850 Sept. Call

An easy way to construct it is by using Excel’s graphs after creating a table with relevant profit-loss points. As an example, we present a long position on EURUSD 1-1.850 sept-2020 Call.

In a long Call position, we buy the right, but not the obligation to purchase the asset at the strike price. Thus, if the asset drops in price, let’s say to 1.0000, we are not obliged to buy at the 1.1850 strike price. This sets the maximum loss to the price paid for the call option, which is $144.

Therefore, we set the cost value (-$144) with a minus sign from 1.0000 to its 1.1850 strike price. That will draw a horizontal line. Then we compute the break-even price (1.1944) and set its profit to zero. We calculate the distance from strike to BE ( 0.00940) and add points every that distance, which should also show $144 profit differences. After creating the table, we can create a graph and display it on the sheet.

Similarly, the same EURUSD 1.185 Short Call option will look like:

In the case of an option seller, he expects the price not to go above the strike price at expiration, but our maximum profit is the option premium ($144). If the price moves above the strike price, his premium will fade and start becoming an increasing loss. That is reflected in the profile.

As for Puts, the EURUSD 1.1850 Long Put profile is shown below:

When we purchase a Put, we buy the right to sell at the strike price. Thus, we expect the price of the asset to drop. But we don’t have an obligation to do it, So, if the asset’s price moves up, our loss will only be the cost of the Put option, $133 in this case. That creates the profit-loss profile shown above.

The short version of the EURSD September Put – when you sell the option instead of purchasing it– is:

In this case, the maximum profits occur when the price at expiration is above the strike price. Prices below expiration will covert that profit into increasing losses.

These kinds of graphs will give you the basic profile in case you don’t have more sophisticated options analytical software but is enough to create the strategies’ profile curves.

Forex Options IV – Volatility

Historical Volatility

Historical volatility is the calculated or statistical volatility of an asset. It merely measures the price fluctuations of a security over a specific time. For example, we can calculate the standard deviation of the EURUSD pair over the last 20 days to get the 20-day historical volatility. Options traders, then, use this value to compute the fair price of a given option. If historical volatility is 25%, it means that the asset’s likely movement within the next 12 months will be in a range of about 25% from the current price ( plus or minus).

Figure 1 – EURUSD daily chart with its 20-day historical volatility curve.

Implied Volatility

Implied volatility represents the volatility of an asset expected by the market over the life of an option. The main difference with historical volatility is that the later is based on past price changes. In contrast, Implied Volatility is the volatility implied by the current price action of a given option. Historical volatility looks at the past, whereas implied volatility reflects the market’s expectations for future volatility.

Figure 2 Implied volatility shift with time and strike price

source: Semantic Scholar

When the expected volatility decreases, the option’s premium drops, and when it moves up, the option’s price goes up. Thus, assets with lower levels of implied volatility will hold cheaper option prices.

Implied volatility changes, as the view of the market participants shift. Options’ sensitivity to the changes in implied volatility varies with the time to expiration and strike to spot Price distance. An option near expiration will be less sensitive to implied volatility changes than a similar option with a longer time to expiration. Also, options with strike prices at the money have the highest sensitivity. In contrast, options deep in the money or out of the money are less sensitive to implied volatility shifts.

How to effectively use Implied Volatility

We can follow the asset’s implied volatility and take note when it peaks and when it troughs historically, to determine when it is relatively high and low.

Fig 3 – EURUSD Implied volatility changes
source: dailyfx.com

Following this procedure, we can determine when option prices are cheap, and when they are expensive. Also, since volatility tends to be mean-reverting and cyclic, traders could forecast a potential move towards its average value.
Volatility forecasting by itself is not a stand-alone strategy but can help traders decide their optimal option selection. For instance, if the options are expensive, and a trader expects this to revert to lower values soon, he may choose to sell instead of buying overpriced options. Strategies following this idea can be covered calls, naked puts, or credit spreads. Also, during low implied volatility, the purchase of options is the best choice. In that case, long calls, or even, a long straddle ( long put + long call) can be profitable.

Recommended reading:
THE OPTION TRADER’S GUIDE TO PROBABILITY, VOLATILITY, AND TIMING , by Jay Kaeppel

Forex Options: Introduction

This article begins a series that will explain the basic concepts of options. We will focus on the basic or vanilla options because we think they are the most used in all markets, and base of all variants, including the infamous binary options.

Options as Insurance

An option was thought of as insurance, where the buyer acquires the right to be compensated if something happens to his main assets. That way, fund managers could hedge the risks of their portfolios. Thus, an option is a derivative from the main asset, which gives the buyer the right, but not the obligation, to buy or sell at a determined price at the expiration date.
Therefore, contrary to the underlying asset, an option purchase offers unlimited gains for a limited loss. In a sense is like a position with built-in stop loss, only that the stop loss does not get executed until the expiration date of that option. This, and its relatively low cost compared with the cost of the underlying asset, has made options a game extremely popular.

The contract

Options are structured contracts between two parties, a buyer and a seller in which the seller takes the obligation to sell a specified asset at a determined price, called Strike Price, at a future expiration date. The buyer also acquires the right, but not the obligation to buy the asset at the strike price.
Option basic classes
There are two basic option classes: Calls and Puts.

Fig 1 – The valuation curve of a Call

Fig 2 – The valuation curve of a Put

A Call offers the buyer the right to buy the underlying asset at the strike price, and a put provides the buyer the right to sell it at the specified strike price, both at a set expiration date. There are two options styles, European and American options. Both are similar. The only difference is that American options allow the buyer to exercise the option at any time before expiration, while the European style may be exercised only on the Expiration date. The difference is subtle but unimportant, as any trader can sell the purchased option instead of exercising it and use the money to purchase the asset.

Option contract detail terminology

The terminology of an option stipulates the asset, expiration date, type, and strike price of the contract. Example:
“EUR-USD December 01 1.20 Call”
This contract states that the underlying asset is the EUR/USD pair, that the expiration date is December 01, the strike price is 1.20, and is a Call.

Expiration dates are usually the third Saturday of the month for monthly options, but there are also weekly options that may expire at a determined day and time.
We can see that for a predetermined asset there can be a lot of different contracts involving different expiries, strike prices, and class (put or call). These contracts are called option chains.

Recommended reading:
THE OPTION TRADER’S GUIDE TO PROBABILITY, VOLATILITY, AND TIMING , by Jay Kaeppel