Options Trading - Part II

Below is a set of common notions associated with options trading. Reading through them will give you a better understanding of what trading options is really about, and how option prices are calculated.

Out of the Money/ in the Money / at the Money

These classification terms are used in options trading to describe the options (and more particularly their strike price) with regards to the price of the underlying market rate at any given time. They also give an indication as to the intrinsic value of a forex option, more precisely: the difference between the strike price and the underlying spot rate. An options contract has intrinsic value when it is in the money.

A call option is in-the-money when the spot rate is above the strike price, and out-of-the-money when the spot rate is below the strike price. The reverse is true for put options: it is in-the-money when the spot rate is below the strike price, and out-of-the-money when the spot rate is above the strike price. When a forex option is out-of-the-money, it expires worthless. When the spot rate and the strike price are one and the same, the option (call or put) is considered at-the-money. In this case, it has no intrinsic value.

• CALL: When current market price is > than the strike price
• PUT: When current market price is < than the strike price

• CALL: When current market price is < than the strike price
• PUT: When current market price is > than the strike price

• CALL & PUT: When current market price = the strike price

On the illustration below, you can see how profit and loss work for a regular call option:

When calculating profit and loss in options trading, keep in mind that the premium must be taken into account. In order to be profitable and cover the cost of the premium, an option must therefore be deep enough in-the-money. So, as you can see on this chart, while an option may be in-the-money, you may still sustain losses.

Calculating Option Prices

When trading options, the premium is automatically calculated according to certain formulas. There are several factors affecting the price of an option, mainly:

• The difference between the spot (market) rate and the strike rate.
• Time until expiration date: Usually, the longer the lifespan of the option, the more expensive the premium. Since the value of an option decreases as the expiration date nears, and since it actually becomes worthless after that date, options are known as “wasting assets.”
• The volatility of the market: This is one of the most important factors in the pricing of a forex option. It measures movements in the price of the underlying spot currency pair. When volatility is high, the probability that the forex option will expire in-the-money is greater and the option seller takes thus a bigger risk and in return for this risk asks for a larger premium. In general, the greater the volatility, the more expensive the option (call or put). In option pricing, two types of volatilities are considered: the historical and the implied volatility. Historical volatility is based on the past performance of the currency rate. Implied volatility reflects how the market itself expects the price to move.

Other factors such as the difference in interest rates and other market conditions affect the option price, albeit in a minor fashion. The theoretical value of an option is usually calculated according to the Black-Scholes model, which is based on physics wave equations. Under this model, volatility is defined as the annual standard deviation of the currency exchange rate.

The total price of an option consists of the intrinsic value added to the time value. Intrinsic value: how far in-the-money the option is (the difference between the strike rate and the spot rate). Forex options that have no intrinsic value are considered out-of-the-money.

Time value (also referred to as the extrinsic value): this is the value of an option beyond the intrinsic value (the difference between the premium and the intrinsic value). The calculation of the time value is based on different factors including the volatility and the spot price of both spot currencies, the time until expiration. As the expiration date approaches, the time value gets closer to zero. A forex option expiring in two months will be more expensive than the same option expiring in one month because the underlying spot rate has more time left to eventually move in a favorable direction. For this extra amount of time, the writer (seller) demands a larger premium.

The Greeks

This colloquial term refers to a series of statistical measures derived from the Black-Scholes formula and represented by letters from the Greek alphabet. They give the trader a better idea of the currency’s past performance.

• Delta: measures the level of correlation between the forex option price and the underlying spot rate. There are several factors that can affect the delta of an option, including a change in volatility or in the underlying forex market rate, or the time that is left.
• Gamma: measures delta’s sensitivity to a change in the underlying spot rate.
• Vega: measures an option’s sensitivity to a change in the volatility of the underlying forex spot rate.
• Theta: measures the option’s level of correlation to time decay.
• Rho: measures an option’s sensitivity to a change in risk-free interest rates.

All these measures are thus interdependent and are subject to constant changes. These measures will give traders an idea of the way the option price will change when the underlying spot rate changes (assuming that all other variables remain constant). Professional traders use the Greeks to calculate the level and the location of the risk (for instance volatility or interest rate).

Not to worry! You don’t need to calculate these numbers yourself when you trade options! Calculators do it for you. However, it doesn’t hurt to know those concepts when you start trading. Whether you are a seasoned trader or new at trading, with Finotec, you will be provided continuous assistance by a dedicated and competent support team. So start trading options with Finotec!