Essential terms to know
Options are simple in principle, but their pricing can be complex. Sellers must be familiar with the terminology and the basic principles of options trading without really going into the complexity of the calculation of the premium price .
What is a derivative?
Think of orange juice. The juice is derived from orange. Currency or Fx option is a derivative of a currency price. Orange price determines the price of orange juice.
Any security whose value is derived from the value of an underlying asset is part of the derivatives market. It is a contractual agreement where a base value is agreed upon by means of an underlying asset, security or futures. Many investors prefer to buy derivatives (like flipping properties by paying reservation deposit upfront) rather than buying the underlying asset.
These instrument can be:
- Equity / Stocks
- Agricultural commodities including sugar, coffee beans, grains, soybeans etc.
- Precious metal like gold and silver, platinum.
- Foreign exchange market instruments.
- Bonds, short term debt securities like T-bills, interest rate futures.
Derivatives Market size and type
The derivatives market is extremely large. It is estimated to be $1.2 quadrillion in size.
The commonly traded derivatives market is divided into two categories: OTC derivatives and exchange-based derivatives.
OTC, or over-the-counter derivatives, are the contracts that are not listed on exchanges and are traded directly between parties. Institutional clients, such as commercial banks, hedge funds, and government-sponsored enterprises frequently buy OTC derivatives from large institutions like investment banks.
Exchange-based derivatives, such as Futures and Future options, are the ones that are listed on public exchanges, such as the Chicago Mercantile Exchange.
Online trading of currencies
The more common derivatives used in online trading are:
- Spot FX: It enables you to speculate on the increase or decrease in prices of spot market currencies that will mirror the movements of the underlying asset, where profits or losses are continually booked as the asset moves in relation to the position the trader has taken. It is traded in a decentralised market and the market makers and brokers are free to set their own capital and margin requirements. In some cases, they even accept US$100 for trading.
- CFD FX: It is very much like spot fx. It is popular in the UK but the regulators in Hong Kong don't permit this instrument.
- OTC Currency Options gives traders the right to buy or sell an underlying asset at a specified price, on or before a certain date with no obligations. The market makers have set minimum capital size as the value of a contract, but brokers can again allow retail investors to trade any size of the contract. They accept even US$250 for trading fx options.
OTC products are more flexible as the brokers accommodate small investors while the exchange-traded products maintain rigidity in terms of margin capital.
The margin capital requirement for Futures Contracts and Futures Options contracts are fixed by the exchanges. The contracts are standardised and unlike Spot Fx instruments or OTC options, brokers can't show flexibility in terms of margin requirements.
- Currency or Fx Futures contracts are an agreement to buy or sell currencies paid for at a later stage but with a set price. Currency Futures are standardized and require minimum initial and maintenance margins fixed by regulated exchanges.
- Currency Futures Options give traders the right to buy or sell an underlying asset at a specified price, on or before a certain date with no obligations. Essentially, the Exchange acts as the counterparty in case of Currency Futures Options while OTC currency options is a bilateral agreement between the buyer and seller.
Who bears the loss when sellers default?
When options are traded on recognized exchanges such as the Chicago Mercantile Exchange, the exchange itself is the counterparty to each trade. So if sellers default due to heavy losses, the exchange must still honour its contracts with the buyers.
Collaterals provided by sellers
In order to protect the exchange from losses, sellers of options are required to lodge via a broker an initial margin or “good faith deposit" which covers a percentage of the initial value of the option, and they must also post at the exchange the cash equivalent of the daily change in price – this is known as Maintenance or “cash” margin.
Actually, brokers decide on who to approve as a seller. In addition to the margins required by the exchange, the brokers also need additional margin deposits. The margin calculation is done dynamically and in real-time both by the exchange and the broker.
Option Premium Price model
It is really not necessary to understand how the pricing is done mathematically. It is sufficient to know that the option premium price is based on some combination of the difference between the current market price and the strike price, the length of time until the option expires, and the probability of an exchange rate movement large enough for the option to be exercised (this is known as “implied volatility”). The smaller the difference between the current market rate and the strike price, the longer the time to maturity, and the higher the volatility, the more expensive the option may be.
How Prices are quoted: Bid/Ask Spread
The bid/ask spread is the difference in price between the buyers and sellers of any option contract. The bid is the price that a buyer is willing to pay for an option while the ask is the price that a seller is willing to pay for that same option. Bid and ask prices usually fluctuate throughout each trading day which can change the spread.
Placing orders: market or limit
You can place a "market" order if you want to buy quickly. If you think the price is not good for you, you can place a "Limit" order setting your own price.
Market orders are transactions meant to execute as quickly as possible at the present or market price. Conversely, a limit order sets the maximum or minimum price at which you are willing to buy or sell.
What does it mean to be Long and Short?
When watching a sports game, would you bet on who’s going to lose?
Essentially, “short-sellers” bet that a currency will fall in price even though they don't own the currency. Long investors bet that the prices will rise. Shorting is quite a strange transaction. You’re selling something you don’t own. This happens in a financial trading market. And the goal is to sell high and then buy low, as opposed to the common game plan of first buying low then selling high.
A black swan is an event or occurrence that is not predicted. It is like an abnormal event. Typically random and unexpected. The market crash of 2008 is such an event.
Contract size is fixed
Currency futures trade in one contract size and so traders must trade in multiples. For example, buying a Euro FX contract means the trader is in actual fact holding say 125,000 Euros.
In-the-money Options settlement/delivery
It takes two steps to settle in cash when the options are delivered on expiry. First your account shows up options contracts converted as Futures since the underlying asset is Futures and not Cash.
If you want to settle by way of cash instantly, you have to first take the delivery in futures and then liquidate in the market and get cash in the underlying currency. For example, the EUR futures market is based upon the Euro to US Dollar exchange rate, and its underlying currency is Euro. In the example above, When an EUR futures contract expires in the money or liquidates futures positions, the holder receives a delivery of $125,000 worth of Euros in cash.
Out-of-the-money options on expiry are all settled in cash
Trades liquidated prior to delivery or expiry are also all settled in cash.
Nuts and Bolts
Call and Put
Call Buyer Long Position)
Call Seller (Short Position)
Put Buyer (Long Position)
Put Seller (Short Position)
When you open positions:
When you buy an option = you pay a premium ($ $) that is taken out of your account.
When you sell an option = you receive a premium ($ $) into your account
When you close positions before the expiration date of options
It is not necessary to hold the options till their expiry. You can buy or sell anytime before the expiration date.
A buyer can offset or liquidate the positions by selling in the market.
A seller can offset or liquidate the positions by buying in the market.
When the open positions expire in the money
If you have sold a call option = at expiration of time period you are short (sold) a futures contract
If you have sold a put option = at expiration of time period you are long (bought) a futures contract
It is a price at which the holder of an options position can buy (in the case of a call option) or sell (in the case of a put option) the underlying security when the option is exercised. Hence, the strike price is also known as exercise price.
Class, style and Expiration
A European-style call/put option places a restriction on the holder to exercise the option only on the expiration date. American-style options place no such restriction but CME offers only European style oons on five products: British pound, Canadian dollar, Euro FX, Japanese yen and Swiss franc futures contracts. There is no risk of early exercise with European style options, which are automatically exercised if they expire in the money. However whether it is American or European style options, the trader does not have to wait for the expiry date to liquidate the positions as long as there is liquidity in the market. Both American and European style options on CME FX futures trade virtually around the clock on the CME Globex electronic trading platform.
The value of an option depends on its strike price's distance and direction from the underlying market changes.
An option can be described as being in any one of three states of moneyness depending on its strike price versus the market price:
- The intrinsic value of an in-the-money option is equal to the absolute value of the difference between the current price of the underlying asset and the option's strike price. or
At-the-money (ATM) : There is hardly any intrinsic value between the current price of the underlying asset and the option's strike price. Zero value. or
Out-of-the-money (OTM) : The intrinsic value of an out-of-the-money option is zero.
Unless the strike equals the market rate, the moneyness of a Put option differs from that of a Call option:
When the strike rate of a long (buy) Put is above the market rate, we say it is in-the-money because the strike allows you to sell at a higher price.
When the strike rate of a long (buy) Call is below the market rate, we say it is in-the-money because the strike allows you to buy at a cheaper price.
When an option is in-the-money (ITM), it is more valuable, i.e. its premium is higher. ITM options are the most expensive to buy, whereas out-of-the-money (OTM) options are the cheapest.
vital Terms a seller needs to focus on
Intrinsic value and Extrinsic Value (also known as Time Value) of In the money options
In options trading, intrinsic value is the difference between the underlying asset's price and the option's strike price.
Intrinsic value only refers to in the money options or when the underlying price is more than the market price – a negative intrinsic value would mean that the options is either at the money or out of the money.
The method used to calculate intrinsic value will vary depending on the type of option that has been bought – in call options, it is the price of the underlying asset plus the strike price, whereas in put options, it is the strike price minus the price of the underlying asset.
In options trading, there is also the ‘extrinsic value’ to consider. Extrinsic value is calculated as the difference between an option's market price and its intrinsic value.
Assuming the Euro Futures price is 1.08235 (similar to a spot price) the Strike Price of a Call is 1.08500 and the premium (ask) is 0.01390 points for the call. The price is more than the underlying price which means the call is out of the money.
The premium has no intrinsic value.
If the Euro Price is 1.08265 and the trader wants to buy the call at a strike price of 1.08000 and the premium (ask) is 0.04000, then the difference between the two is: strike price (1.08000) - the underlying price (1.08265) = 0.00135
Extrinsic value will be: 0.01350. Intrinsic value: 0.00265 when the option premium value is 0.04000.
The term intrinsic value refers to the amount of money assigned to an asset as determined through fundamental analysis. Intrinsic value can be determined by summing the discounted stream of future income derived from an asset.
Example of Put Options: If the Euro price is 1.08235 and the trader wants to buy put at a strike price 1.08100 and the premium (ask) is 0.01190 points for the put . The price is less than the underlying price which means the put is out of the money. The premium has no intrinsic value.
If the Euro Price is 1.08265 and the trader wants to buy the put at a strike price of 1.08400 and the premium (ask) is 0.03900, then the difference between the two is: strike price (1.08400) - the underlying price (1.08265) = 0.00135
Extrinsic value will be: 0.02550. Intrinsic value: 0.001350 when the option premium value is 0.03900.
The intrinsic value of any out-of-the-money options , be it a put or call, is zero.
When buying an option, the trader pays a premium, the open premium. The premium value changes depending on the changes in the underlying market. The premium of a Put option increases as the market falls. Why? Because the Puts strike price becomes more attractive relative to the market price. The premium of a Call option increases as the market rises. Why? Because the Calls strike price becomes more attractive relative to the market price.
Calculation of P & L
The profit or loss for each contract is done taking into account the contract size, tick size, current trading price, and what you bought or sold the contract for.
The profit/loss on a trade in the currency futures is calculated as the difference between the entry price and exit price (in ticks), multiplied by the tick value, and multiplied by the number of contracts taken on the trade.
For example, if the strike price of a EURUSD call option is $1.08500 and the price of the underlying futures is $1.09000, then the intrinsic value of the call option is $0.00500 or 5 ticks or 10 half-ticks.
The value of a CME contract for EURUSD future option is US$125,000. Each half-tick tick value is USD6.25. If you gain 200 half-ticks (or 100 pips in fx spot terminology) on expiration your profit is USD1,250.
Each currency contract may have a different tick value and it can be checked on the CME website.
For trading Exchange-traded Future Currency Options, the actual physical transaction of the currency pair is not required and you do not have to exercise the option to receive your profit until the expiry.
Instead of settling ITM options with cash, you will get delivery of futures. If needed, you can then liquidate futures for a cash settlement.
Instead, the running profit or loss of the option position is calculated for you and when you close the option trade, or it expires, cash is credited to your free balance (if the option has premium value).
Trades can be closed any time before expiry (during trading hours) to lock-in profit or reduce a loss.
Very rarely a trader takes delivery of the currency futures for speculating further in the Futures Market on the movement of the currencies. Over 95% of options transactions are closed out with an offsetting sale or purchase of the same option, or options expire without any remaining value.
Terms used in risk management process
Adjustment of Options Trades - Protecting your Pocket
You won't always have great choices at your disposal when an option trade goes against you This is where the practise or experience counts. You don't have to panic. You are in this risk business by choice. You better be prepared to face surprises and learn to face them all the time. In other words, take the bull by the horns.
I play conservatively and never over-leverage myself upfront. I always keep 50% of my capital as reserves. This cash buffer not only gives me comfort to trade leisurely but also greater flexibility to repair or wiggle out of a position if the trade moves against me
Front Month and Back month
A front month refers to the contract month with an expiration date closest to the current date. The front month is sometimes called nearby month, nearest month, or spot month. The delivery date for the underlying futures may be very closer.
Contracts that have later expiration dates than the front month contracts are called the back month contracts.
The front month contracts are considered to be most liquid and usually, they have the smallest spread between the future price and spot price.
A trade is said to be rolled when the timeline is extended for a losing position to recover. Rolling a trade involves closing the existing position and replacing it with a new one. It is part of risk management exercise and helps gain time for the trade to become favourable.
The rollover, or “the roll”, is a critical juncture in which a trader decides to move the position from the soon-to-expire front month contract to a deferred contract by simultaneously offsetting the nearby position and establishing a like position in a contract further in the future, known as back month contract.
Option Spread strategy
A spread consists of opening two opposite positions to hedge against risk. An options strategy typically involving two options on the same, single underlying asset. This is part of techniques to transfer or distribute risk.
intrinsic value, time value, total premium value in visuals
What is Premium value?
When buying an option, the trader pays a premium, the open premium. The premium value changes depending on the changes in the underlying market.
The premium of a Put option increases as the market falls. Why? Because the Put's strike price becomes more attractive relative to the market price.
The premium of a Call option increases as the market rises. Why? Because the Call's strike price becomes more attractive relative to the market price.