Puts are the mirror image of calls (Be sure to read the lesson on call options here). They work in the same way, but are used when you think the exchange rate is going to fall. If a call gives you the right to freeze the buy price on a forex pair, a put allows you to freeze the sell price on a pair. Just as you can use a call in place of an outright long forex spot position a forex put is a good alternative for a short spot position. Puts also have expirations dates on the third Friday of each month, they have strike prices and are similar in cost to calls. It may be easier to understand how they work with a simple analogy.

Imagine that you know that the housing market is about to collapse (not that hard to believe right now)  You find a house that is currently valued at $220,000, but you’re fairly certain it’s value will fall shortly. You decide to arrange a contract with a buyer that he will buy that house from you for $200,000 at some time over the next year.

You pay your “buyer” $1,000 for the contract. But, you still don’t own this house yet because you think home prices are going to fall. Your plan is to buy the house, once the price has fallen to $180,000, and then sell it to your buyer, who is obligated because of the contract, to buy it from you for $200,000.

You pay your “buyer” $1,000 for the contract. But, you still don’t own this house yet because you think home prices are going to fall. Your plan is to buy the house, once the price has fallen to $180,000, and then sell it to your buyer, who is obligated because of the contract, to buy it from you for $200,000.

Everything works out perfectly and 6 months later, following a collapse in the housing market, you have bought the home for $180,000 and sold it to your buyer for $200,000. You made a profit of $19,000 ($20,000 - $1,000 contract price). You were able to do this without tying up your money and your contract buyer took most of the risk.

There are only three things that could happen to you as the “house trader” in this situation.

In the analogy, we talked about a contract price of $200,000. This is the same as a put strike price. Our house purchase contract had a time-frame of one year, which is like an option’s expiration date. Finally, the collapse in housing prices is similar to a decline on a forex pair.

There is, however, one major difference between the contract in the analogy and buying a put: Flexibility. A put (the contract) will begin rising in value as prices drop and will fall in value as prices rise. You don’t actually have to execute the contract, buy the pair and re-sell it.  You can simply sell the contract for a profit as its value rises. This allows you to exit for a profit or to stop losses at any time before expiration. Because the underlying market, the forex, is so liquid, forex options also have plenty of liquidity (lots of buyers and sellers).

The simplest way to take advantage of a put in the forex is to buy a put in the same situation that you would normally short the forex pair itself. Let’s walk through an example.

In the chart below you can see that the USD/JPY was consolidating for a few weeks in January and February. When the market finally broke out below support on February 27th there was an opportunity to short the pair, or buy a put.

Based on your analysis, you think the USD/JPY will eventually reach 103.00. So imagine that you bought a put with a strike price equal to the current spot price of the forex pair itself at 106.50. That put would have cost $200, and would have given you control of the equivalent of a $10,000 lot size contract for 45 days.

Subsequently, the market moved below your target price of 103.00 (chart below), and the put rose in value to $450. This created a return on your original $200investment of 125%.

Now, let’s contrast this with an outright spot position. In this case, we will assume that you are using a stop loss of 100 pips. Each pip is worth nearly a dollar and we can use the stop loss as an approximation for the investment required to enter the position.

Comparison:

Option purchase price:           $150
Option sale price:                    $450
Return on investment:              200%

Spot position profits:              $350 (approximately $1 per pip)

Investment – stop loss:         $100

Return on risk:                           350%

At first glance you can see that the spot position looks a little better than the put option, and this is normal in a very basic trade. However, this assumes that all has gone well with the trade. In the video we will make a similar trade comparison that accounts for a stop loss being triggered.

Best time to use an option

One of the best situations to use an option is when you are anticipating a large multi-day or multi-week movement in the market, but you also expect a lot of volatility during that timeframe. The option is a great choice during volatile market conditions because it acts as its own stop loss. The most you can lose is the amount you spent on the option contract when you purchased it. Regardless of how far the market rises, you cannot lose more on your put than you originally invested.

The important thing to remember is to use the investing strategy that best suits market conditions and your forecast the best.

What's next?

In the next lesson we are going to go into options pricing in detail. We will look at the advantages and disadvantages of different strike prices and we will talk about how an option’s value changes as prices rise or fall. Once you understand these concepts you will find that options have more advantage than you may have guessed.

Watch the video below, then proceed to the next lesson: How Forex Options are Priced

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Koji  - V Good   |2009-06-05 05:30:36 Very informative! Thank You!

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