| Forex Options Part 1: Start with Call Options |
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When debating the best subject for a new course we asked ourselves: “What are the most important things new traders should learn?”
The answer we came up with was simple: The same things the professionals know. One of the major strategies used successfully by professional traders, is often overlooked by retail traders. That strategy is Options.
Options have been available to currency futures traders (and traders in just about every other market) for years. However, they have only been available to retail forex spot traders recently. Options are not marketed or offered as widely by dealers, as they are more complicated than buying and selling lots of pairs. But there are many dealers who do offer options, and once understood, options are an invaluable addition to your portfolio.
So with that out of the way, let's get started. Proceed to Lesson 1 below!
Who are options for? There are two types of traders that can take advantage of options. Chances are pretty good you will find that you belong to one of these two groups.
How does an option work? There are two types of option contracts – calls and puts. In this first lesson we will talk about call options in detail. You will learn why a trader would buy them, what their characteristics are and one of the simplest strategies you can use to put them to work.
Here is a good analogy for what an option is and how it works. Imagine that you are in the market for a particular classic car. You think that the value of that car is going to rise in the future and intend to sell it later for a profit. In this situation you are essentially acting like a speculator or a trader. Now imagine that you have found someone that has this exact car, which is currently worth $10,000. You think it may be worth $12,000 next month which makes this a pretty good deal. However, since you are only looking to sell the car and not use it as a driver why should you incur all the costs of moving and storing the car as well as tying up $10,000 of your own money?
You decide to offer the current owner $300 to save the car for you for 30 days and to fix the price at $10,000. If during the next 30 days you want to buy the car for $10,000 the seller promises to sell it to you for that price. If you decide that you don’t want the car after all you can walk away from the contract and the seller keeps your $300. The owner of the car accepts your proposal and you both sign a contract. That contract is an “option.”
There are three things that can happen at this point. 1. The price of the car falls: You find out in 30-days that the price of the car is falling, and now similar autos are selling for $8,000. At this point you would probably decide not to “exercise” your contract to buy the car for $10,000 and you take the $300 loss. You lost money, but your risk was fixed at $300.
2. The price of the car rises: The market for this car model goes up, as you anticipated, and now the car is worth $12,000. You go to the seller and buy the car for $10,000. He keeps your $300 in addition to the $10K you paid him, but you sell the car for $12,000, and net a positive $1,700 ($2,000 profit, less the $300 you paid the seller to hold the car and price for you.) This is a return on your $300 investment of 566%.
3. The price of the car stays the same – You have paid $300 to have the right to buy the car for $10,000 but since prices have not moved, you have chalked it up to a loss and moved on to other opportunities. The benefit is that you only needed $300 to secure the opportunity, and you would have been able to use $9,700 of your money to do other things during the month.
As you can see, the major benefit from the use of an option contract is that you don’t have to tie up as much capital to control a large amount of opportunity. And best of all, no matter how high the price of the car rises, when you bought the option you froze the price, so the profits are yours to keep (minus the premium, or the price you paid to buy the option in the first place). Your upside potential is unlimited while your risk is fixed at the premium price.
And that’s the second benefit; You are taking less risk in absolute dollars. The owner still bears the downside risk on the car.
Now, If you are really smart, you would not even take delivery of the car even if the price does rise. Why go to all the hassle of coming up with the $10K, when you just want to turn around and sell it anyway.You are only speculating on its rise in price.
Instead of buying the car (exercising the option), you can profit by selling the contract to someone else for more than you paid for it. Another speculator or car collector could buy that contract from you after prices have risen. Because the contract is more valuable you still make a profit. That way you get the benefits of the rise in the car’s value but don’t have to deal with the car itself.
Each of the components of this story has an equivalent in the options market. Let’s define some terms and then look at a specific example in the forex market.
Now let's look at a specific example of a call option contract that would have worked out successfully.
The EUR/USD has been on quite a trend but was stuck within a channel in February. If you had been looking to benefit from a breakout to the upside but were concerned about being whipped out on a stop loss if the market turned around at resistance you could use a call option instead. At the time, the EUR/USD was priced at about 1.4850. Let’s assume you thought at the time the market was likely to break out to 1.5200 or better. You could have bought an option with a strike price of 1.4850 that expires on the third Friday of March anticipating that a rise over those next few weeks. That option would have cost about $150, and given you control of the equivalent of a $10,000 or mini-lot.
As anticipated, the market broke out and met the profit target within two weeks. That option earned the profits of a 350 pip move, and retained some of its original value when you purchased it. It is now worth $400. You decide to sell the option for a profit and move on to another opportunity.
Now, let’s compare this trade to an outright spot position. In order to do that we have to assume that you would have used a stop loss. Because a spot forex position is a margined position we can use the stop loss price as a comparison to the price of the call option above. We will do that because the stop loss is what you would have put at risk since that is what you could lose if the position goes bad. Assume in this case, that you would have given the market 100 pips for a stop loss.
Option purchase price: $150 Option sale price: $400 Return on investment: 166%
Spot position profits: $350 ($1 per pip) Investment – stop loss: $100 Return on risk: 350%
The positions look similar and do favor the spot position in this case. But consider this: What happens if the market moves through your stop loss? Have you ever entered a position, which was ultimately a good trade but were stopped out on a whipsaw? Do you get back in the position if the market then rebounds?
Entering this trade twice after being stopped out increases your potential loss total (“investment”) to $200, and reduces your return on the spot position to 175%, which is now very similar to the option trade.
The option can only lose what you paid for it, and in that respect, it acts like its own stop loss. And in later sections, we will talk about how you can drastically outperform rate of return of a spot contract with a call option by looking at different strike prices further out in time.
Please note, that we are not advocating you replace your spot forex trades with options trades. We are simply showing options as an alternative, and in later lessons we will use the information in this article as a basis for showing ways in which more sophisticated options offer even greater advantages and potential returns.
Watch the video below, then proceed to the next lesson: Put Options
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3.25 Copyright (C) 2007 Alain Georgette / Copyright (C) 2006 Frantisek Hliva. All rights reserved." |
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