Forex Options Part 3: How Forex Options are Priced

 

 

Now that we’ve learned about calls and puts, it’s time to learn how they are priced and how those prices move. The beauty of options are that they can be adjusted for your own risk bias and trading objectives. Previously in this course, we looked at options as an alternative to an outright spot position but they can also be used to in combination with a spot position to hedge risk and improve returns.

 

You will need to understand this information to use the strategies we will be talking about next in the course. And as you can probably guess, the best strategies are saved for last.

 

Option pricing

Option prices are based on the underlying pair’s price and have two components: Intrinsic Value and Premium.

 

You should remember from the last lesson, that the “strike price” of an option is the price at which your option may be exercised. If you buy a call option on the EUR/USD with a strike price of 1.4950, you have the right to buy the pair at that price.

 

 

A call option which has a strike price lower than the current price of the pair is considered “in-the-money,” because it already has intrinsic value. For instance, if you bought a call on the EUR/USD with a strike price of 1.4950 and the EUR/USD was trading at 1.5000 at that time, this pair is “in the money,” because you have the right to buy it for 1.4950 and you could sell it for 1.5000.  An “out-of-the-money” call option is one which has a strike price higher than the pair’s current price.

 

Intrinsic Value

The intrinsic value of a call option is the difference between the current spot price and the strike price if that strike price is lower than the current spot price. The option we bought for 1.4950 above has 50 pips worth of intrinsic value because the spot price was 1.5000. An out of the money call option has no intrinsic value at the time it’s bought, because its strike price is higher than the current spot price. But an out of the money call option will gain intrinsic value when the price of the pair rises above the strike price.

 

Option pricing is typically shown by exchanges and brokers in a chart format called an Option Chain. Below is a very simple example. Note there are many strike prices offered, both in, and out of the money. You may also notice that the cost of each option is a little more than its intrinsic value. Let’s talk about what that means next.

 

Time value

All options have a cost or premium associated with them. Even an out-of-the-money option costs something. This premium includes the option’s intrinsic value mentioned above if the option is in the money and an extra amount called time value. The extra amount of an options premium is called time value because it shrinks as the option gets closer to expiration.

 

In the sample Option Chain below you can see several option strike prices with a breakdown of each strike price’s intrinsic and premium values.

 

 

As you’ll notice from the chart below, the total price of an option is the sum of the intrinsic value and the premium price.

 

EUR/USD Spot price = 1.5000

Calls

Strike Prices

Cost

Time Value

Intrinsic Value

1.4850

 $     203

 $        53

 $     150

1.4900

 $     170

 $        70

 $     100

1.4950

 $     140

 $        90

 $       50

1.5000

 $     110

 $       110

 $        -  

1.5050

 $       90

 $        90

 $        -  

1.5100

 $       72

 $        72

 $        -  

1.5150

 $       55

 $        55

 $        -  

 

Puts are priced similarly, but reversed, because a put (or the right to sell an exchange rate at a certain price) will grow in value as prices drop. Therefore the higher strike prices will have a lot of intrinsic value. The chart below will illustrate this concept for puts. Notice that the lower strike prices have no intrinsic value because you are buying the right to sell the pair for a specific price.

                            EUR/USD Spot price = 1.5000

Puts

Strike Prices

Cost

Time Value

Intrinsic Value

1.4850

 $       55

 $        55

 $        -  

1.4900

 $       72

 $        72

 $        -  

1.4950

 $       90

 $        90

 $        -  

1.5000

 $     110

 $       110

 $        -  

1.5050

 $     140

 $        90

 $       50

1.5100

 $     170

 $        70

 $     100

1.5150

 $     203

 $        53

 $     150

           

In real life the option premiums for calls and puts are not a perfect inverse of each other but they would be very close if the current spot price was exactly equal to one of the strike prices.

 

In the video below we will look at a list of option strike prices and their costs, so you can see how they rise and fall as you go further in-the-money or out-of-the-money. I will explain what you look for when choosing a strike price and this will set the foundation for the next options strategies we will be discussing.

 

Watch the video below, then proceed to the next lesson: Protective Forex Options

 

 

 

Comments Add New
ian   |2009-04-29 22:17:57
hi, i've got a bit of a dumb question. Where can i find a list for the options
symbols for forex pairs? can't find them on CBOE website . only one i know is
XDE- eur/usd that you have in video
thanks
John Jagerson  - Not a dumb question   |2009-04-30 01:42:01
You can find a lot more about these options on the exchanges that list them.
www.ise.com and www.phlx.com both list these options and have a great deal of
free information and education about them. I think the ISE is the best
resources. On their website click on options exchange and then products traded.
You will find it there.
Doug Endsley   |2009-10-19 01:20:45
In the video a second website is shown for placing a trade different from CBOE.
At the top of the site it says Core Client Option. I don't find a site similar
to this when I look online. Is there a specific website name you can give me to
access this site? Thanks. By the way this series has been great. This is what
I've been looking for to trade the AUD/USD
John Jagerson  - Platform   |2009-10-19 02:33:57
Doug,

I used the IKON platform for this example. They are a spot dealer that
also offers options. I tend to prefer exchange traded options but this was a
convenient way to illustrate the point.
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