To this point, in the options essentials course, we have focused on buying options. For the next few sections we will be talking about selling or writing options. What you learned about options pricing is going to be expanded here. This is an exciting topic for me. You will find that options sellers in the equity or futures markets are very passionate about the strategies available to options sellers.

Part of this excitement comes from the fact that all of the disadvantages of buying options are advantages for options sellers. We will discuss what those are and how they can help you as an FX options trader. In this section and subsequent two sections we will discuss how writing options can be used in three specific strategies.

Selling or writing an option means that you are opening an option trade by selling the option short. When you enter this trade, you are paid the option cost or premium up front. There are a few significant factors to consider as you evaluate and enter this trade. We will walk through each of these issues in a case study.

Selling the option:

When trading spot FX positions, the market must move the direction you forecasted or there will be no profits, only losses. In the following example you will see how selling an out of the money option gives your trade room to play without accumulating losses.

Our case study will be on the GBP/USD during the decline in January and February of 2008. The market had retraced to resistance on 1/30 (point A.) Forex traders would normally evaluate a short spot trade to take advantage of a move to the downside but writing an option may be more attractive and provide a little more room for a volatile market. In this case, assume that a call was sold with a strike price 130 pips above the close price on 1/30 at 2.0000.

It may sound a little unexpected to sell a call if you are bearish but remember that now you are an options seller not an options buyer so things are reversed. You want the market to fall so that the call you sold will fall in value or expire worthless. If you were bullish and wanted to sell an option, you would sell a put because you want the market to rise and that put to fall in value.

In the case study assume that you sold a call with about 2 and ½ weeks until expiration on 2/15 and that call is worth $145 for a $10,000 lot. That is the equivalent of 145 pips.

What you want in this trade is for the exchange rate to stay below your strike price until expiration. In the image you can see two dotted line barriers that outline where you want prices to stay and within what time frame.

Let’s review the features of this trade.

1. You are opening the position by selling an option

You are the seller of the option, which means that you are being paid the premium when you open the trade. You will lose money if the market rises above your strike price but will keep the entire premium if the market closes at expiration on or anywhere below the strike price.

2. Breakeven is equal to the strike price + premium paid

The premium you are paid can offset some losses if the market rises near expiration. Your break even point at expiration is actually 145 pips above the strike price you sold (2.0145) because that is equal to the premium you were paid.

3. Time value works in your favor

This is an out of the money option with no intrinsic value. The entire premium is made up of time value which melts or reduces the closer you get to expiration and the more the market trends down. 

4. Exiting the trade

You can exit this trade whenever you need to. If the market has fallen and the value of the call has declined to a desirable level, you can exit the trade by buying the call back for a cheaper price. You are then free to decide whether you want to sell another call for a larger premium. Alternatively, you can let the call expire on 2/15 when it has no value and keep the entire premium.

5. Margin:

Selling a call means you have an obligation to cover losses that may occur if the trade moves against you. For example, if the market begins to rise, the call will gain in value and could become worth more than you sold it for. Most brokers or options dealers will require you to cover this trade with a margin requirement.

As a general rule of thumb, you are usually going to have to cover an options position with 20% of the notional value when trading exchange options, which is a leverage ratio of 5:1. Options offered by dealers usually have a much higher leverage ratio closer to spot leverage rates. If you are a very aggressive trader, working with an options dealer rather than a broker may be the best way to go.

Watch the video below, then proceed to the next lesson: Selling Straddles

Comments

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robert   |2009-10-23 22:07:42 question If you get paid a premium say for selling the put in the example above cant the Buyer of the option cut his/her losses by selling out before the expiration date thereby decreasing your profit thanks

JOhn Jagerson  - Cutting profits   |2009-10-24 12:33:55 No they can't. You aren't really trading with a specific person. If you sold it short you will have your gain or loss realized when you buy the option back to cover or the option expires - whichever comes first.

robert  - question   |2009-10-30 12:23:31 Thanks John -- yes - after going through some more info - all clear now!! Found your information in particular the small videos very very helpful cheers robert

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3.25 Copyright (C) 2007 Alain Georgette / Copyright (C) 2006 Frantisek Hliva. All rights reserved."