Vanilla Options School

Lesson 1: New to Trading

Welcome to the financial markets! This lesson will provide you with an introduction to trading products such as gold, oil and currency pairs.

Imagine, you lived in the 1900s and you had to travel from the United Kingdom (UK) to the United States (US). You would need to find a way to exchange currency at a fair rate just before you left the UK or just after you arrived in the US. Neither task was easy without being swindled. Also, how would you confirm if you received fair market value?

Today, millions of investors trade on the financial markets each day to buy or sell a variety of financial products. Location is unimportant as an investor in Japan could trade the same product and see the same prices as an investor in London. Banking systems and online trading platforms have made this possible.

Therefore, if you were making the same trip between the UK and the US today, you can check the internet and receive up-to-date market data on currency pair values before going to exchange your currency. Then, when you exchange your currency, you made a financial transaction with the financial markets and without realising it, you are already participating in the financial markets!

Many investors have a physical need to trade, i.e., they require the actual delivery of the product they are buying. Airline companies need to buy jet fuel, jewellers need to buy gold, grocery stores need to buy fruits and vegetables, etc.

Not all investors require the physical delivery of a product. Instead, they buy a product with the expectation that its value will increase and they will be able to sell it for a profit. These investors are called speculators and they are only interested in the changing price of a product. A common term used for this type of trading is ‘Contract For Difference’ (CFD), whereby the speculator takes out a contract and their profit or loss depends on the difference between the price they bought at (purchased) and the price at which they close (sold). It’s the same as buying a house for £100,000 and in 5 years’ time being able to sell it for £150,000, the difference and profit are £50,000.

Historically, especially before the internet, trading in the financial markets was expensive and unattainable for private investors. These days online trading is so advanced it’s possible for anyone to open a trading account and buy any financial product such as shares, commodities or currency. Remember, this does not involve physically buying products but merely booking a trade to profit from an increase in price.

Using online trading you can even sell a product that you don’t own! ‘How do I sell a product that I don’t own’, I hear you ask! You can use your investment (in your own currency) as a deposit to sell any other product. If you sold a product and its price fell you would profit. Let’s consider the house example again, imagine you sold a house for £200,000 and a year later you were able to buy it back for £100,000, the difference and your profit is £100,000. In this situation you receive a higher amount than you have to pay back. It is the same when you sell on a trading platform. For example, if you hold a trading account in Euros you can place a deposit in Euros to facilitate a trade to sell Crude oil. The trading platform calculates the deposit you must put down based on the amount of oil you want to sell.

So far it should be clear that you can speculate on almost any financial product in the world. If you expect the price of that product to increase you would buy it and if you expect the price of the product to decrease you would sell it. There are a few more things you need to know…

Leverage

Leverage is the practice of putting a small amount of money down (as a deposit) to trade a much larger amount. For example you could put down £1000 to trade a £100,000 deal. The smaller amount put down is called the margin and you may have heard of the term ‘margin trading’. The ratio between the smaller and larger amount is the leverage. For example, a £1000 deposit to trade a deal size of £100,000 is 1:100 leverage; that is £1000 fits 100 times into £100,000.

Why do we have leverage? You don’t actually need the full deal size to be able to trade it you only need to cover the risk. Leverage allows you to take advantage of small moves in the market and to increase your investment return. Of course at the same time your risk is also increased. Short-term traders sometimes only hold a trade for a few minutes! However, the duration of your trade will entirely depend on your market outlook.

The Spread

The spread is the difference between the price you can buy at and the price you can sell at. If there was no spread the sell and buy price would be the same, this doesn’t exist in the financial markets. The bank or broker will apply a spread as their charge for providing you with a trading service. If you are trading via an exchange you may also have to pay commission as well as the spread. If you are trading currencies (also known as forex) or commodities on an online platform usually no commission is applied.

Liquidity

Liquidity is simply a statement of how much a certain product is traded. A product that is traded often is said to be liquid which means there are plenty of buyers and sellers available in the market making it easy to find prices to trade at. A product with a smaller number of buyers and sellers, therefore traded less, is known as illiquid. The price of illiquid products are more likely to jump around as there isn’t enough ‘flow’ in the market to support smooth pricing.

How does liquidity effect you?

Products that are more ‘liquid’ tend to come with smaller spreads, i.e. smaller charge to trade. This is because the high turnover of trading in the product makes it possible for banks and brokers to lower costs. For example, Euro against US dollar (EUR/USD) is the most traded currency pair in the world and comes with the tightest spread whereas US Dollar versus the South African Rand (USD/ZAR) is less liquid and therefore has a higher spread.

Controlling maximum risk

When you use leverage to buy or sell you may be exposed to a large risk (and you may also be exposed to a large profit!). To control your total risk you can use a stop-loss order. This order automatically closes your trade at a certain price on reaching a certain amount of loss. When the trade is closed you are not exposed to losing more money. For example, if you buy gold at $1200 per an ounce because you expect the price to rise and, at the same time, place a stop-loss order at $1100. If gold price subsequently falls your trade will be closed at $1100 and your loss is limited from that point. Is it wise to access and manage your risk for every trade you place.

Capturing profit

A take-profit order closes a trade at a certain price level to lock-in profit. You decide where to place the take-profit order depending on your target price. For example, you buy EUR/USD at 1.3500 and you expect it to rise to 1.3600, you can place a take-profit order to automatically close the trade at 1.3600 and lock-in profit at that point. You cannot make more money once the trade is closed and the final profit is credited to your trading account.

Derivatives

This sounds like a very complicated word that only bankers would know, but it really isn’t! When we say something has derived from another the exact same meaning applies to financial derivatives. It is a broad way of describing a financial product that has come from another financial product. For example, a Futures contract allows a trader to buy or sell a product in the Future rather than today. The price of the Futures contract is derived from the present value of the product. Hence, a Futures contract is a derivative. Another example are Option contracts, the price of an option is derived from the present value of the product. The present value is called the underlying market. For example, the present price of EUR/USD is the underlying price of a EUR/USD Option contract.

Lesson 2: What are Options?

Congratulations! You have decided to learn about options. This may be your first lesson ever or a refresher course, but our goal is to make an introduction to options interesting and easy.

Did you know options are another way to trade the currency, gold or oil markets?

How to trade the markets?

The previous lesson explained how to speculate on changes in an asset’s price. An asset is simply anything of value that can be converted into cash such as gold, oil, currencies, company shares, etc. To benefit from a rising asset price a trader may buy the asset and to benefit from a falling price a trader may sell the asset. These types of trades are known as ‘contract for difference’ (CFD) since you are profiting or losing by the difference between the opening and closing price. In the modern world of trading investors use electronic (or online) trading to access a desired market and place a trade.

What is an option?

An option is a contract that gives the right, but not the obligation, to buy or sell an asset at a certain price until a certain date in the future (expiry date). The financial asset in our case is a currency pair or commodity (such as gold or crude oil). For example, if you want to secure a price to buy 100 ounces of gold at $1300 over the next month you could do this through purchasing an option.

Option contracts can be described as an insurance policy to insure the price of an asset and, similar to an insurance policy, to purchase an option you must pay a premium. The premium cost is the option holders maximum risk.

Examples

Today, you are exposed to options in many aspects of your life and you may not even realize it! Here are some examples:

  • Have you ever paid a membership fee to a club or store just to receive lower prices on goods? You were sold an option which gives you the right to buy an amount of goods at a certain price over a certain duration and when you execute it you receive your goods at a lower price.
  • If you want to buy something in the future, like a house, and want the ability to buy it without competing against others, you may pay a premium to secure a certain price and take it off the market. You would gain if house prices rise because you have secured a lower price. Alternatively, you would lose the premium paid if you chose not to buy the house.
  • Companies you buy products from may trade options to hedge their costs, e.g. Jewellers have to buy gold often and they may secure a certain price for gold over a certain period of time, eliminating risk of price fluctuation, through purchasing an option.

 

The above examples use tangible assets and it is much easier to imagine buying and selling physical assets. When you transcend to Over-the-Counter electronic trading, you will be trading intangible assets since you will never actually receive the goods you are buying or selling.

If you are wondering if you can just simply buy and sell options to make money, yes you can! Our lessons start by teaching you the most simple trades to speculate a rising or falling asset price.

Many people think of the stock market when they think of options. However, the foreign exchange market also offers the opportunity to trade forex options and our lessons will focus mostly on these unique derivatives.

Why trade options?

You may be wondering, “Why purchase an option instead of directly buying or selling the asset in the underlying market?” Good question, because…

  • When buying an option, your downside risk is limited (to the premium you paid to purchase the option).
  • When buying a Call option, you have unlimited profit potential.
  • The premium paid for an option can be less than the money paid up-front for a ‘spot’ or ‘forward’ trade.
  • You can build strategies to trade many different market outlooks, such as a strategy profiting from a move in either direction.
  • Options can be used to insure an open forex deal (or a portfolio of deals), to trap profit and/or limit risk.

Good news, if you did not understand any of these terms, they will be explained in the next few lessons!

Lesson 3: Call and Put Options

There are only two types of options; a Call and a Put.

  • A Call gives the right, but not the obligation, to buy an asset at a certain price until expiry.
  • A Put gives the right, but not the obligation, to sell an asset at a certain price until expiry.

The certain sell/buy price fixed via an option is called the strike price. The asset’s market price relative to strike price is a major factor determining the value of an option.

Strike price versus market price

An option with a strike price better than market price is worth more than a similar option with a strike worse than market price. Since an asset’s price is always fluctuating, the value of an option will change as the underlying market moves around. Through purchasing a Call option you can fix a (strike) price to buy an asset at its current market value. If the asset price subsequently rises it will be cheaper to buy at the option’s strike price hence the option contract becomes more valuable. The below example explains this in more detail.

Example: Buying a Call option to trade an uptrend

Say EUR/USD is trading at 1.10 and you are expecting positive economic news from Europe which will strengthen the Euro and push EUR/USD higher. However, you don’t have the confidence to buy the pair directly in the market because there is a possibility you face a large loss if Euro price plummets. Instead you may buy a Call option, giving you the right to buy at a certain price for a period of time.

You choose to buy a Call option giving you the right to buy 10,000 EUR’s at 1.11 over the next month. This option costs you a premium of $50.

Call option:

  • Strike is 1.1100
  • Expiry date is 1 month from today
  • Premium to pay is $50

 

Now, imagine the scenario in which EUR/USD does what you expect, it moves up and before the end of the month it has moved to 1.15. You decide to ‘exercise’ your option, that is via your option you buy EUR/USD at 1.11 and at the same time you can sell in the market at 1.15. You are buying at 1.11 and selling at 1.15, thus profiting from the difference of $0.04 for every Euro traded. In this example, that is €10,000 x 0.04 = $400. The graph below shows how this would look.

 

Then, if you then subtract the premium you paid for the option, you will have $350 net profit ($400 – $50).

On the other-hand, if your bet goes against you and EUR/USD price falls, it’s not like a direct trade in the market where your maximum risk must be managed with a stop-loss. The maximum risk when you buy an option is the premium paid at open, in this case that is $50. Even if EUR/USD price headed to zero, you are not stuck in an increasingly losing trade. The graph below shows how losses are incurred when buying EUR/USD directly in the market at 1.1000.

 

Buying a Put option to trade a downtrend

Under the same reasoning, you can buy a Put option to trade a falling currency price. If the price falls the Put option allows you to sell at a higher price than the market. The difference between your Put option’s strike rate and the market rate at expiry is the option’s payout (and net profit is the payout minus the premium paid for the option).

Cash-settled options

On ORE’s web-trading platform, options are cash-settled. This means the actual physical transaction of the currency pair is not required and you do not have to ‘exercise’ the option to receive your profit. Instead, the running profit or loss of the option position is calculated for you and when you close the option trade, or it expires, cash is credited to your free balance (if the option has premium value). Trades can be closed any time before expiry (during trading hours) to lock-in profit or reduce a loss.

Premium value

We have mentioned when buying an option you pay a premium, the ‘open premium’. Whilst you hold an option, the premium value changes depending on changes in the underlying market:

  • The premium of a Put option increases as the market falls. Why? Because the Put’s strike price becomes more attractive relative to the market price.
  • The premium of a Call option increases as the market rises. Why? Because the Call’s strike price becomes more attractive relative to the market price.

 

The difference between the ‘premium at open’ and ‘premium now’ is your running profit or loss. Here is an example of the ‘profit/loss’ of a USD/CAD option trade:

 

Lesson 4: Trading a Trend

This lesson will teach you how to buy options to trade a trend.

You should be familiar with the method of selling or buying in the underlying market to trade a downtrend or uptrend, respectively. You may add a stop-loss order to control your maximum loss. If the market reaches the stop-loss your position is closed at a loss.

The chart below shows the profit or loss of a long (through buying) position over a range of market rates. The dotted gray zero line is the break-even point. Anything above the gray line is profit and anything below is a loss. The trader bought in the market at rate A. He will profit if the markets rises and will be stopped-out (red line) if the market falls.

Buying an option to trade a trend

Through buying a Put or Call option you can profit from a downtrend or uptrend, respectively. The maximum loss when you buy an option is limited to the premium paid at open. You manage your total risk upfront and it cannot be increased during the trade. Your position stays open no matter how the market moves and you do not have to utilise a stop-loss order. Hence, buying an option to trade a trend may be useful in a volatile market where managing risk can be difficult.

Trading an upward trend

To trade an upward market trend (uptrend), you can either go long (through buying) in the underlying market or buy a Call option. The charts below shows you the difference between the two trades.

 

If the market rises, both the buy trade in the underlying and the Call option will bring a profit, and if the market falls, both will bring a loss. However, the Call option will never get stopped-out and loss is limited to the premium paid at open.

Trading a downward trend

To trade a downward market trend (downtrend), you can either go short (through selling) in the underlying market or buy a Put option. The charts below shows you the difference between the two trades.

 

If the market falls, both the sell trade in the underlying and the Put option will bring a profit, and if the market rises, both will bring a loss. However, the Put option will never get stopped-out and loss is limited to the premium paid at open.

In summary:

 

Lesson 5: How to Open a Trade

The Web-Platform has different trading modes: Basic and Advanced. You choose a mode depending on your experience.

How to Open a Trade in Basic Mode

Basic mode allows you to choose the strike price, expiry, and amount to trade (or deal size). These parameters affect the cost of an option i.e. the option’s open premium. Longer-dated options are more expensive, you could view this as buying yourself more time. An option with a larger amount to trade is also more expensive. As a default, the strike price is set to 0% which means the strike equals the currency pairs market price at the time of execution. You can change the strike price before execution by entering a different percentage or typing in an exact price.

 

Payout Scenarios

Using the Scenario tool, before you trade you can checkout your potential profit:

 

Upon clicking the button, you will be presented with a chart and table showing the option trade’s payout over a range of market prices. You can choose to view payout at expiry or present pay-out.

The example below is a Scenario chart for a buy EUR/USD Call expiring in 7 days. The vertical axis represents ‘profit or loss’ and the horizontal axis represents the currency pair’s market price. The horizontal zero line is the breakeven point. Anything above the zero line is a profit and anything below is a loss. The blue vertical line indicates EUR/USD current market price. You can change the pip step value to view your payout over a smaller or wider range of market rates.

In the below image, as EUR/USD market price rises profit increases and as the market falls, the option makes a loss which is limited to the premium paid for the option, 200.95 USD.

 

Open positions

From the open position’s page you can analyse your open profit/loss and can close individual or multiple positions. You do not need to wait until the expiry date to close a position, you may close a position during any trading hour to lock-in profit or reduce a loss.

 

Lesson 6: Strike and Moneyness

Strike price versus market price

An option with a strike price better than market price is worth more than a similar option with a strike worse than market price. The value of an option depends on its strike price’s distance and direction from the underlying market changes.

An option can be described as being in one of three states depending on it’s strike price versus the market price: In-the-money (ITM), at-the-money (ATM) or out-of-the-money (OTM).

An option is in-the-money (ITM) when the strike rate is better than the underlying market rate.

An option is at-the-money (ATM) when the strike rate equals the underlying market rate.

An option is out-of-the-money (OTM) when the strike rate is worse than the underlying market rate.

These states are known as an option’s ‘moneyness’. Unless the strike equals the market rate, the ‘moneyness’ of a Put option differs from that of a Call option:

 

When the strike rate of a long (buy) Put is above the market rate, we say it is in-the-money because the strike allows you to sell at a higher price. When the strike rate of a long (buy) Call is below the market rate, we say it is in-the-money because the strike allows you to buy at a cheaper price.

When an option is in-the-money (ITM), it is more valuable, i.e. its premium is higher. Hence, ITM options are the most expensive to buy, whereas out-of-the-money (OTM) options are the cheapest. Paying more for an option means you are risking more, however an ITM option has a higher probability of returning a profit. Buying an OTM option is a smaller risk, but the probability of profit is lower. In each trade, you enter a strike rate depending on your market outlook and risk appetite.

Use the platform to select either a Call or Put option and experiment by entering different strike rates. You will see, as you adjust the strike, the premium-to-pay changes.

Buying an at-the-money Put option

If you buy a Put with a strike equal to the market rate, we say it is at-the-money (ATM). If the market falls, the strike will become in-the-money (ITM) since the sell price of the strike is higher than the market. But, if the market rises, the strike will be out-the-money (OTM). The diagram below demonstrates this concept.

 

Buying an at-the-money Call option

When you buy a Call option with a strike equal to the market rate, it is ATM. If the market rises, the strike will become ITM since the buy price of the strike is cheaper than the market. But if the market falls, the strike will become OTM. The diagram below demonstrates this concept.

 

Examples of buying Long Call options – ATM, OTM, ITM

The following three images depict EUR/USD buy call options ATM, OTM, and ITM.

 

In the ATM buy call option image above, the underlying EUR/USD rate was trading at 1.12252 and valued at 345.47 USD.

Setting an option with a strike of 0% means the strike rate equals the market rate at open.

 

In the OTM buy call option above, a strike price +2% above market has been selected. This means the trader is reserving a worse rate than what is currently available in the market and the following happens – the value of the option decreases to 54.50 USD.

 

In the ITM buy call option above, a strike price -2% below market has been selected. This means the trader is reserving a better rate than the market and the following happens – the value of the option increases to 1,190.11 USD.

Lesson 7: Premium Value

When trading options, you are trading premium value. If you buy an option, you want to sell it in the future for a higher premium, and if you sell an option, you want to buy it back for less.

Buying an option

In the example below, the option holder has paid 200.25 USD to buy an option and now it is worth 471.37 USD, hence the profit is 271.12 USD.

 

Selling an option

In the example below, the option writer (seller) received 450.95 USD when he sold an option and now it is worth 149.56 USD, therefore he can buy it back for less and his profit is 301.39 USD.

 

Premium value is comprised of two parts: Intrinsic value and time value. These values change as the underlying market changes.

Premium = Intrinsic Value + Time Value.

Intrinsic Value

This is the portion of the premium that depends on the difference between the strike and the market rate. When the option is in-the-money (when the strike rate is greater than the market rate) the option has intrinsic value. But if the option is out-of-the-money or at-the-money, the intrinsic value is zero. When intrinsic value is zero, it does not mean the premium is zero as it may still have time value!

Calculating intrinsic value

The platform automatically calculates the premium value for you and it is updated every second the market is open, but it’s always good to know the workings behind it.

Example

Let’s say you buy a EUR/USD Put with a strike of 1.3600 and an amount of 100,000 EUR, as per the option trade details in this image:

 

If the underlying market is trading at 1.3500, your strike rate (to sell) is 100 pips better than the market, hence your trade is in-the-money (ITM). We calculated this by subtracting the market rate (1.3500) from the strike rate (1.3600) giving us 0.0100 or 100 pips. In fact, whenever the market is trading below 1.3600, the Put option has intrinsic value.

More specifically, when the market rate is 1.3500,

Intrinsic value = Amount x Difference between strike and market rate

= 100,000 x (1.3600 – 1.3500)

= 100,000 x 0.0100

= $1,000.

Therefore, the Put option’s premium = $1000 + Time Value.

On the other hand, if the market is trading at 1.3600 or higher, the strike rate is not greater than the market rate, hence intrinsic value = 0 and premium is comprised of time value only.

Time value

Time value, also known as extrinsic value, is the portion of the premium left after deducting the intrinsic value and is determined by external factors: Time Value = Premium – Intrinsic Value.

Premium can increase or decrease depending on time value and the two main external factors are time until expiry and implied volatility.

Options with a longer expiry are more expensive since you are buying more time for the market to move in your favour. The opposite is also true, options with a closer expiry cost less. When holding an option, the expiry date moves closer for each day passing. The time value portion of the premium declines reflecting this. At expiry, time value equals zero and the premium equals intrinsic value only. The process of time value declining each day towards zero until expiry is known as Time Decay.

Time decay is bad for an option buyer, who wants the premium value to increase, and good for an option seller, who wants the premium value to fall.

The Scenarios trading tool gives the option’s premium value over a range of market prices. You can choose to view the premium now or premium at expiry. The values at expiry have no time value, hence they are intrinsic value only. The premium now is an indication of the option’s value before expiry, hence there is time value. We can conclude time value is the difference between premium now and the premium at expiry.

Net Present Value (NPV)

Net Present Value (NPV) figures are an indication of what your option trade’s ‘premium now’ would be if the market moved. The indication is based on the current market environment. The Scenarios and Sensitivity trading tools provide NPV values over a range of market rates. This is useful to forecast the trade’s pay-out.

If you are long (through buying) an option, then the NPV value will be positive and this is the amount you will receive when you sell your option back. The example below is a snap-shot of the sensitivity table for a long Call option. The NPV column indicates how the option’s value will change as the underlying market moves.

 

If you are short (through selling) an option, then the NPV value will be negative and this is the amount you will pay to buy back the option. The example below is a snap-shot of the sensitivity table for a short Call position. The NPV column indicates the cost to the seller as the underlying market moves.

Volatility

The marketplace’s volatility affects an option’s premium (time value portion). Expected volatility, known as implied volatility, is based on marketplace consensus. If the market is expecting more volatility, you will pay more for the option. This makes sense because the more volatility in the underlying asset, the more likely the market will move in your favour.

There are other external factors affecting the extrinsic value, and to fully understand all these elements, you will to learn them via The Greeks available in later lessons.

Tips:

  • If the implied volatility increases after an option trade has been purchased, this is good for the buyer and bad for a seller. Buyers like increasing volatility!
  • At any time, your option’s premium will be at least the intrinsic value. At expiry, time value = 0 and the premium = intrinsic value.

Lesson 8: FX Hedging with Options

Hedging is a method used to reduce the risk of an existing investment at times of adverse movements in the market. Options are commonly used by private investors and businesses to hedge open or future deals. The latter is useful for companies who have overseas invoices to pay or profits to receive in a foreign currency.

Insuring an open forex deal

If you have an open deal and you want to lock-in the profit or limit the loss, but don’t want to close your trade, you could hedge it with an option. The effect of an option hedge is to keep the profit potential open, yet limit (hedge) any loss.

  • If you are long (through buying) in the underlying market, you can hedge with a buy Put option trade. If the market falls, the Put will gain in value covering the loss from the underlying long position. If the market rises, the Put will lose to a limit whilst the value of the long position will increase with no limit.
  • If you are short (through selling) in the underlying market, you can hedge with a buy Call option trade. If the market rises, the Call will gain in value covering the loss of the underlying short position. If the market falls, the Call will lose to a limit whilst the value of the short position will increase with no limit.

Limit loss example

If you held a long 100,000 AUD/USD position from 0.8000 and the current price is 0.7700, you would be at a loss of $3000 (100,000 x 0.0300). To limit further loss without closing the trade, you could hedge through buying a Put with a strike of 0.7700 and amount of 100,000 as displayed in the diagram below.

 

If the market price continues to go down, your long 100,000 AUD/USD position will lose $10 for every 1 point decrease in the underlying market (100,000 x 0.0001 = $10), but the Put option will gain in value and cover (or hedge) the loss. If the market rises, your AUD/USD position will profit $10 for every 1 point up, but the Put option will lose a maximum of 433.51 USD (the premium paid).

Hedging costs

The maximum cost involved is the premium paid for the option. Always evaluate this cost, and if you expect the market to trade sideways, you may not need to hedge. The use of options is to insure an open deal when you expect adverse moves in the market.

Costs can be decreased by reducing the expiry date, reducing the amount you hedge, or choosing a strike rate worse than the underlying market rate (an out-of-the-money option). Reducing the amount or choosing a worse strike rate means you are insuring only a portion of the underlying deal’s profit. If you had chosen a strike of 0.7600 (instead of 0.7700) in the above example, your option would have cost you less but your insurance wouldn’t start until AUD/USD trades below 0.7600 hence you are putting another $1000 at risk.

Locking-in profit example

The same concept applies to locking in profit of an open deal. Using the same example as above, but instead you sold at 0.8000, you would be profiting by $3000 at 0.7700. To lock-in this profit without closing the trade, you could hedge through buying a Call with a strike at 0.7700. Thus, if the market continues to fall your underlying AUD/USD position will continue to profit. Whilst if the market turns upwards, your AUD/USD position’s profit will be reduced, but the Call option will gain in value and cover (hedge) the loss from profit.

Hedging currency rate exposure – Exporters and importers

Any company exporting and importing goods overseas will have currency rate exposure. This exposure could be on a future invoice to pay or future profits needing to be repatriated into a domestic currency. Through buying Call and Put options, a company may eliminate this risk.

 

For example, let’s say an Australian based travel company ‘Deluxe Travel’ has to pay a US-provider $100,000 in a month’s time. Deluxe Travel could secure a AUD/USD forward rate to sell at 0.8000, which means paying AU$125,000 for the US$100,000. Alternatively, they could buy a Put option (option to sell AUD, buy USD) with an amount of AU$125K, strike of 0.8000, and expiry of one month. It costs US$1040 to buy the Put option contract. The below image demonstrates how to set-up the option in the trading platform.

 

Note: The ‘amount’ of the option is entered in the amount of the first (base) currency of the pair. In this case, it is AUD.

You could view this as an insurance policy giving Deluxe Travel the right to exchange at 0.8000, but not the obligation. If the market falls, then Deluxe Travel has secured a higher rate through its option. On the other hand, if the market rises, Deluxe Travel can take advantage of the higher rate, since they are not tied into exchanging at 0.8000.

Let’s look at the savings made in these scenarios:

  • AUD/USD rate falls to 0.7500 and Travel Deluxe exchanges at this lower rate, therefore paying AU$133,000 for the US$100,000. That is an extra $8,000 to pay (compared with AU$125K) , however the option pays-out a profit to cover the loss from 0.8000.
  • AUD/USD rate rises to 0.8500 and Travel Deluxe exchanges at the higher rate, therefore paying only AU$117,600 for the US$100,000. That is a AU$7,400 savings compared with fixing the rate at 0.8000.

Under each of these scenarios, a premium was paid for the option. This must be considered in the hedging costs. Hedging with options may be used when you expect adverse movements or volatility in the market.

Lesson 9: Option Strategies

his lesson will teach you how to build option trading strategies. If you are not familiar with the process of buying an option, please refer to the lesson ‘Call and Put options’.

The Advanced trading mode of the platform allows you to build strategies. You can enter this mode by clicking on a link ‘go advanced’.

 

A strategy is when you execute more than one option at the same time; buying and selling Calls and Puts in different combinations to take advantage of market moves in many different ways. Note: The Advanced mode of the platform does not allow you to trade ‘Naked Options’ when selling. For more information on selling options, please refer to lesson ‘Selling options.

Below, we teach you some of the most popular strategies, but there are endless possibilities and always more to learn.

The Long Straddle

The long straddle is commonly used over news announcements and major economic events to trade an increase in volatility. To execute this strategy, you buy a Put and Call at the same time with the same strike, expiry, and amount. This results in a profit if the market moves in either direction; the Put option will bring a profit if the market falls and the Call option will bring a profit if the market rises.

AUD/USD Long Straddle example:

 

The above image is an at-the-money straddle where both the Call and Put are set with strike rates equal to the underlying market (0%) at execution. The strike rates do not have to be at 0%, but they do have to be the same.

The chart below shows the strategies’ profit or loss at expiry over a range of market rates. The dotted grey line highlights when profit/loss equals zero (the break-even point). Anything above the grey line is a profit and anything below it is a loss. The letter indicates the strike rate. If the market moves far enough in either direction past the break-even points, the strategy is profitable. But if the market rate does not break-out in either direction, the strategy creates a loss. This ‘V’ shaped chart is a classic Long Straddle strategy.

 

Advantage:

  • You can profit from a move in either direction.
  • Your maximum loss is limited to the premium paid at open
  • You will not get stopped-out

Disadvantages:

  • It involves a higher premium cost compared with trading in one direction.
  • As time passes and the options get closer to expiry, time value is highly against you since both legs are decaying.

 

Strategy trade walk-through:

The example below gives you a step-by-step guide to setting up a strategy in Advanced mode.

1. You build your strategy one line at a time. Set-up the first line as you wish. For example, you set-up a EUR/USD Call option, then tick buy.

2. You click on the button ‘turn into strategy’ to add a new line and set this line as you wish. For example, if you want a Long Straddle strategy, you set this second line as a EUR/USD Put option, then tick buy.

 

3. You alter the strike, expiry, and amount on all lines, and then assess the total amount ‘to pay’ (or amount ‘to receive’) of the strategy. If you have evaluated your risk and profit potential using the Scenario and Sensitivity trading tool and are happy, then click ‘trade now’ to enter the trade.

4. If you want to publish your strategy in the strategies marketplaceTM so other traders may view and trade your strategy, click the ‘publish’ button.

The Long Strangle

You would also use this strategy to trade an increase in volatility. It is very similar to the Long Straddle but the Call and Put have different strike rates.

EUR/USD Long Strangle example:

 

In the example above, the Call and Put have strike rates out-of-the-money, thus making both options cheaper to buy compared with at-the-money options. However, compared with a Long Straddle strategy, the underlying market needs to move further before one of the options is in-the-money.

The chart below shows a Long Strangle strategies’ profit or loss at expiry over a range of market rates. The letter A is the strike rate of the Put option and the letter B is the strike rate of the Call option. If the market moves far enough in either direction past the break-even points, the strategy is profitable. But if the market rate does not break out the strategy, it creates a loss.

 

Advantages:

  • Can profit from a move in either direction
  • It is cheaper to buy compared with a Long Straddle
  • You will not get stopped-out and your maximum loss is limited to the premium paid at open

Disadvantages:

  • Break-even points, at expiry, are further away compared with a Long Straddle (as observed in the chart)
  • Time value is highly against you

 

The Bull Spread

This strategy allows you to trade an expected rise in the underlying market and, at the same time, limits the loss and profit potential. To execute this strategy, you buy a Call and sell a Call, at the same time, with matching expiries and amounts but different strike rates. The strike rate of the sell Call option must be higher than the buy Call option.

It costs less than buying a Call option by itself because you pay a premium when you buy an option and you receive a premium when you sell. In this case, you are receiving some premium back through selling. However, the strike price of the sell option limits the profit.

EUR/USD Bull Spread example:

Step 1. Set-up a EUR/USD Call with strike rate at-the-money. It costs $785 USD as seen in the example below.

 

Step 2. Click ‘turn into strategy’ to add a line and sell an equivalent option with a higher strike. Since you are selling, you will receive a premium from this line. In this case, we placed the strike at +1% and received $168.81 back, hence the net premium to pay has been reduced to $592.65. This reduction also includes a discount on the spread charged, which is given when you simultaneously buy and sell an option of identical type.

 

The effect of adding a sell option has reduced the total premium to pay, but has also limited the profit potential. The profit is limited at the strike of the sell option no matter how high the market rate moves. In this example, if the market moves above 1% of its value at the time of opening the strategy, then the profit from the option will remain the same. You may treat this higher strike as your profit target.

The chart below shows a Bull Spread strategies’ profit or loss at expiry over a range of market rates. The letter A is the strike rate of the buy Call option and the letter B is the strike of the sell Call option. If the underlying market moves up past the break-even point, the strategy is profitable to a limit. But if the market rate moves down, then the strategy creates a limited loss.

 

A Bull Spread strategy can also be created through selling a Put and, at the same time, buying a Put with a lower strike price. The buy Put limits the loss of the sell Put. The lesson ‘Selling Options’ explains this in further detail.

The Bear Spread

This strategy is a similar concept to the Bull Spread, but you are trading an expected down trend through buying a Put and, simultaneously, selling a Put with a lower strike. Your total premium to pay is reduced through the sell Put option, but the strike rate of the sell option limits the profit potential.

EUR/USD Bear Spread example:

Buy a Put with a strike of 0% (at-the-money) and a sell Put with a strike of -1% (out-the-money). The total premium to pay is around $522. I.e., through the sell option, the maximum loss has been reduced by $225.

 

As the market rate falls, the strategy will return a profit. However, the profit is limited by -1% of the market’s value at the time of opening the strategy. No matter how far the market falls past this level, it will still return the same profit.

The chart below shows a Bear Spread strategies’ profit or loss at expiry over a range of market rates. The letter B is the strike rate of the buy Put option and the letter A is the strike rate of the sell Put option. If the underlying market moves down past the break-even point, the strategy is profitable to a limit. But if the market rate moves up, then the strategy creates a limited loss.

 

A Bear Spread strategy can also be created through selling a Call and, simultaneously, buying a Call with a higher strike price. The buy Call limits the loss of the sell Call. The lesson ‘Selling Options’ explains this in further detail.

Bull and Bear Spread Strategies

Advantages:

  • You can reduce the premium, thus reducing your maximum risk in the market.
  • The loss from time decay is less since you will receive decay from the sell option as you get closer to the expiry date.

Disadvantage:

  • Potential profit is limited

There are many strategies you can incorporate in your trading. You can find a list of those strategies here.

Lesson 10: Selling Options

This lesson will teach you how to use the Advanced mode to sell options.

When you buy an option, you pay a premium to do so. If you are the seller of an option, you receive the premium. The seller is the other side of the trade; if the buyer is making a profit, the seller is losing and vice-versa.

Take the example of a Call option. A buyer of a Call will receive a profit as the market rises and, simultaneously, the seller of the Call will be at a loss. The seller must then pay the profit to the buyer.

So, how does an option seller make money? An option seller receives premium when they sell, i.e., they receive their profit upfront. However, they are liable for any profit which needs to be paid out to the buyer. The seller of a Call option wants the market to stay at or move below the strike rate and the seller of a Put wants the market to stay at or move above the strike until expiry. If this happens, the option is worthless and the seller gets to keep all the premium received without having to pay anything to the buyer.

The charts below demonstrate the difference between buying a Call (long Call) and selling a Call (short Call). On the left is the buy Call chart and on the right is the sell Call chart. Notice how these charts are reflections of each other on the x-axis meaning the profit or loss of one is the exact opposite of the other.

 

Tips:

  • When you buy an option, you lose on time decay every day until expiry. But when you sell an option, you collect the time decay! The closer the seller’s open position is to expiry, the more time decay they will have collected.
  • If implied volatility increases, the premium of an option increases. This is good for the buyer, but bad for the seller. The seller will benefit if implied volatility decreases.

Covering a ‘sell’ option

When buying an option, your loss is limited and your profit is unlimited. The opposite is true when you are selling an option. Your loss is unlimited and your profit is limited. The maximum profit a seller can achieve equals the premium they collect from the buyer at the time of execution.

Selling an option as a single trade is called trading ‘naked’, since you are exposed to an unlimited amount of loss. In the platform’s Advanced mode, you cannot sell ‘naked’, instead you must cover the options you sell.

An option is covered by another option if they are both on the same asset (e.g., EURUSD), the same type (Call / Put), the same expiry, and the amount of the ‘Buy’ option is equal or higher than the amount of the sold option.

For example, if you sell a EUR/USD Call with strike 1.3300, you will be exposed to an unlimited risk if EUR/USD rises. However, if you buy an equivalent Call but with a strike of 1.3500, it means your risk is limited at 1.3500 and above. The image below shows how this trade looks in the platform. The amount received from the sell Call option is 1,125.43 USD and the amount paid for the buy Call option is 144.61 USD, hence the net amount received is 1004.82 USD (including the spread rebate from the broker).

 

The scenario chart below demonstrates the covered Call’s pay-out: If the market declines by expiry, you will get to keep all or part of the premium you received at open, and if the market rises, the loss is limited to $990.22 from market rate 1.3500 and above. You may notice this as a Bear Spread strategy, as described in the ‘Option Strategies’ lesson. You are trading the expectation the underlying market will fall.

 

To execute a Bear Spread strategy using Call options, the strike of the buy Call trade must be above the strike of the sell Call trade. This is the point at which the risk is limited.

If you move the strike of the buy Call below the strike of the sell Call, then you have changed the strategy into a Bull Spread. Now, you are trading the expectation the underlying market will rise, which is demonstrated in the Scenario chart below. The construction of the Bull Spread strategy is described in the ‘Option Strategies’ lesson.

Covering sell Put trades

You cover sell Put options through buying a Put option. If you place the strike of the buy Put trade below the strike of the sell Put to limit the risk as the market falls, you are trading a Bull Spread strategy, therefore expecting the underlying market to rise.

If you place the strike of the buy Put trade above the sell Put, you are changing the strategy into a Bear Spread and trading the expectation the underlying market will fall.

In summary…

 

 

 

 

Advantages:

  • You can trade the expectation the market will not move, or will stay above/below a certain price.
  • Using a strategy where you sell a Call & Put concurrently, you can trade the expectation the market rate will stay in a certain range. See the Short Straddle or Butterfly strategy to learn how.
  • As time passes, you receive more premium due to time decay, from your sell option.

Disadvantages:

  • You pay spread twice when covering your sell option. The platform does give you a spread discount when you trade more than one option.
  • You must pay for the buy leg, hence you are receiving less premium overall compared with selling an option ‘naked’. However, the cover means you are not exposed to unlimited risk!

Trade walk-through

Below gives you a step-by-step guide to setting up a covered sell option.

1. First, set-up your sell option by choosing the type, strike, date, and amount.

The example below is a sell Put in AUD/USD with a strike of 0.9500 and an expiry of 7 days, hence the trader believes the AUD/USD rate will be equal to or above 0.9500 in 7 days’ time. From this option, the trader will receive $1205.95.

 

2. Click the ‘turn into strategy’ button to add a new line for the buy Put option. The expiry and amount must be the same. Your choice of strike depends on where you want to take risk. In the example, a strike of 0.9300 has been chosen. Therefore, if the market moves lower than 0.9300, the loss is limited.

 

3. Check your pay-out and risk using the Scenarios tool. The platform will show you how much you will receive or pay for the option including the margin to risk. If you are happy, click ‘trade now’ to enter the position.

Lesson 11: The Greek Definitions

Now, it’s time to learn the Greeks and their super powers! The Greek values can be used to measure risk to find the best trading opportunities. The platform’s Sensitivity trading tool gives indicative Greek values over a range of market rates.

In this lesson, we give you an overview of each Greek. When you are ready, go to the next and final lesson for ‘The Greek calculations’!

Delta

Unlike a trade in the underlying market whose value per a point stays the same, the value of an option for every point’s movement in the underlying market is constantly changing. The Delta can be used to measure the value of an option as the market moves. This is useful to monitor directional risk so you know how much your option’s value will increase or diminish as the underlying market moves.

The Delta represents the option’s equivalent position in the underlying market. For example, a EUR/USD Call option with a +50,000 EUR Delta is equivalent to a long (through buying) 50,000 EUR/USD position in the underlying market. Conversely, a EUR/USD Put with a -75,000 EUR Delta is equivalent to a short (through selling) 75,000 EUR/USD position in the underlying market.

The Delta is constantly changing as the underlying market moves. Options further in-the-money (ITM) have a higher Delta. This indicates that ITM options are worth more per pip movement in the underlying market and out-the-money options are worth less per pip.

The table below shows the range of Delta values for a GBP/USD Call option in the amount of 100,000. As the GBP/USD rate rises, the option is moving further in-the-money and the Delta rises. On the other hand, as the market falls, the option moves further out-the-money (OTM) and the Delta falls towards zero.

 

The Delta is also known as the ‘hedge ratio’, since it gives the amount which must be traded in the underlying market in order to hedge the option.

Gamma

The Gamma reveals how much the Delta will change if the underlying market moves by 1%. This provides information on how the Delta will change as the market moves. A larger Gamma means the Delta is more sensitive to movements in the underlying market.

In the platform’s Sensitivity table, the Gamma is given as an amount in the traded pair’s base currency.

If you bought a EUR/USD Call option with a Delta EUR 30,000 and a Gamma EUR 20,000 and the underlying market rises by 1%, then your Delta will increase to EUR 50,000 (30,000 + 20,000).

The Gamma is useful when using the underlying market to hedge options, since it gives an idea of how much you need to hedge in the underlying if the market price moves up or down 1%.

Vega

The Vega shows the sensitivity of the option to the underlying market’s volatility. You should know from Lesson 4, as implied volatility increases the option’s premium increases.

The Vega amount, given in the second currency of the pair traded, is how much the premium will change for every 1% change in implied volatility.

The Vega for a buy Call trade in the Sensitivity table below, is currently at 75.64 USD. This means if implied volatility is increased by 1%, then the option’s premium will increase by 75.64 USD, and if the implied volatility is decreased by 1%, then the premium will decrease by 75.64 USD.

 

Note: Volatility is the amount the market price fluctuates without regard to direction. Hence, implied volatility and Vega could increase even if the market is moving against you.

Theta

The extrinsic portion of an option’s premium decays each day as the option gets closer to expiry. At expiry, the extrinsic value has completely decayed leaving intrinsic value only. Theta indicates how much the option’s premium will decay each day, i.e., it is a measure of the rate of time decay.

The Sensitivity table below indicates the Greek values of a EUR/USD buy Call option. Theta is currently -43.65 USD meaning, as long as all variables remain the same, a day later the premium will have decreased by 43.65 USD.

 

When trading a short (sell) strategy, you will see a positive Theta value. This is because an option seller collects Theta each passing day. Time decay is good for an option seller, but bad for an option buyer.

Rho

Rho measures the sensitivity of an option to change in interest rate of either the base or secondary currency of the traded pair. This is the least important Greek as options are less sensitive to interest rate changes than to other parameters, however it’s worth mentioning. If the interest rate change is in your favour, then the premium will increase by Rho percent for every 1% increase in interest rate and the vice-versa is true, too. Time is also a factor here as over a longer time more interest is received or paid, hence the Rho is larger.

 

 

Lesson 12: The Greek Calculations

It’s time to learn how you can use the Greeks to make trading decisions. Persevere with your learning here as it’s your gateway to becoming an Option’s Master!

Delta

Unlike a trade in the underlying whose value per point stays the same, the value of an option for every point’s movement in the underlying is constantly changing. The Delta can be used to measure the value of an option as the market moves. This is useful to monitor directional risk so you may know how much your option’s value will increase or diminish as the underlying market moves.

The Delta is expressed as a percentage with respect to the option’s total amount. It is written as 0.0 to 1.0 or 0.0 to -1.0 depending on the position’s direction.

In the trades’ Sensitivity table, you will see the Delta expressed as an amount in the base currency of the pair you are trading. For example, if the pair traded is EUR/USD, the Delta is an amount in Euros. This Delta value is simply a percentage of the option’s total amount. If the EUR/USD Call option has trade amount 100,000 EUR and a 0.5 Delta, then the Delta in Euros is 50,000 (50% of 100,000).

The Delta represents the option’s equivalent position in the underlying market. For example, a EUR/USD Call option with a +50,000 EUR Delta is equivalent to a long (buy) 50,000 EUR/USD position in the underlying market. A EUR/USD Put with a -75,000 EUR Delta is equivalent to a short (sell) 75,000 EUR/USD position in the underlying market.

Note: The sign of a Delta is related to the direction of the equivalent position in the underlying market, hence long Calls have positive Deltas and long Puts have negative Deltas.

A higher (absolute) Delta value is desirable for an option buyer, whilst a Delta close to zero is desirable for the option seller; a buyer wants their option to become more valuable whilst a seller wants the option to become less valuable.

In the table below, observe the Delta for a long (buy) GBP/USD Call option in the amount of 100,000 GBP. As the market rises, the Call is moving further in-the-money and the Delta increases towards 100,000 (100% Delta). On the other hand, as the market falls, the option moves further out-the-money, and the Delta falls towards zero.

 

As an option moves further in-the-money (ITM), the Delta’s absolute value rises. It is becomes more valuable for each pips (or points) movement in the underlying market.

Note: If you are an option seller the Delta value is the negative of the option buyer’s Delta. For example, if a long (buy) Call option has a Delta of +60,000, the equivalent short (sell) Call option has a Delta of -60,000, and if a long Put option has a Delta -40,000, the equivalent short Put option has a Delta of +40,000.

 

Delta can also be interpreted as an approximate probability that an option will expire in-the-money. For example, Delta values:

  • 0.10 (or -0.10) 10% chance of finishing in-the-money
  • 0.90 (or 0.90) 90% chance of finishing in-the-money
  • 0.50 (or -0.50) 50% chance of finishing in-the-money

In relation to the option’s moneyness, the general rules are options:

  • Less than 0.50 (or -0.50) are out-the-money
  • Greater than 0.50 (or -0.50) are in-the-money
  • Equal to 0.50 are at-the-money

Lastly, as volatility increases, the Delta of an out-the-money option increases, and as volatility decreases, the Delta of an in-the-money option increases.

Delta Hedging

As demonstrated above, the Delta value indicates the option’s equivalent position in the underlying market. Hence, to hedge an option, you take the opposite position in the underlying market. For example, a GBP/USD Call option with Delta value +50,000 GBP can be Delta hedged by selling 50,000 GBP against USD in the underlying market.

An option trader finds this technique desirable if they do not want to be exposed to changes in the underlying market price. You would want to do this if you have a book of open options and you want to negate the risk of market moves without having to close the options. Additionally, you may have a view on expected volatility and want to trade only it, hence you need to reduce the effects of other factors influencing the premium value.

For example, let’s say you thought implied volatility in the 1-month EUR/USD option was overpriced, therefore you want to short (sell) the volatility. You could sell an at-the-money Call option with an amount of 100,000 EUR. Remember that selling an option means you benefit when volatility falls. The Delta is -0.5 (since this is an ATM option) amounting to -50,000 EUR. To eliminate the risk occurring when the underlying market moves, you can buy 50,000 EUR against USD in the market. This gives the Delta neutral position. If your view is correct, you will profit via the short Call option with zero risk as the market moves around as long as you continue to update the Delta hedge.

Delta hedge trade walk-through

Step 1: Check your option’s Delta value using the Sensitivity table in the open positions page.

 

In this example, the Delta of the long Call GBP/USD option is 51,868 GBP.

 

Step 2: Take the opposite position in the underlying market. In this case, sell 51,868 GBP against USD.

It’s that simple. You have now created a Delta hedge on your Put option.

The Delta of your option will change as the underlying market moves. To keep a perfect neutral Delta hedge, you would need to constantly adjust your position in the underlying market. To do this every time the market moves is an impossible task and the spread charges will eat up your profit. Instead, you could chose to review your Delta based on one of the following:

  • Time based – every t days (depending on the time until expiry)
  • Price based – rebalance in response to a certain price movement in the underlying market
  • Delta bands – when the Delta exceeds a certain level, rebalance the hedge

In summary, the Delta hedge is a strategy to reduce market movement risks involved in an option’s trade whilst sustaining the opportunity to profit from change in volatility. If you are long in an option, the time decay will work against you, whilst if you are short the decay is with you.

Gamma

The Gamma is the rate of change of the Delta with respect to the movement of the rate in the underlying market. In the Sensitivity table, Gamma shows how much the Delta will change if the underlying rate moves by 1%.

Gamma is always a positive value, therefore you add Gamma to the value of the current Delta to estimate the new Delta in a rising market and you subtract Gamma from the current Delta to estimate the new Delta in a falling market.

Example 1.

Underlying GBP/USD price = 1.6800

Long Call option with Delta = 30,000 and Gamma = 20,000

 

Example 2.

Underlying EUR/USD price = 1.3600

Long Put option with Delta = -40,000 and Gamma = 30,000

 

The Gamma is useful when using the underlying market to hedge options, since it gives an idea of how much more or less you need to hedge in the underlying market if the market price moves by 1%. A larger Gamma means the Delta is more sensitive to a change in the underlying market price, which means a larger risk or reward. A smaller Gamma means the Delta is less likely to change as the underlying market moves. This is desirable when Delta-hedging is used to maintain a hedge over a wider price range.

Note: If you are an option seller, you are short Gamma. Hence, if the underlying market moves in your direction, the Delta will tend towards zero.

The Gamma of ATM options near expiry increases, whereas the Gamma of ITM and OTM options decreases. The chart below shows the behaviour of Gamma relative to time until expiry and the option’s moneyness. Notice the peak at time = 0 for an ATM option.

 

How to trade it: One theory is to buy a short-dated, slightly OTM option. You obtain the option cheaper (minimising the risk), and if you are right on the direction, there is a lot of upside as the Gamma increases drastically towards expiry if the option nears ATM.

Implied Volatility (IV)

Before describing the Vega, let’s begin with volatility.

The volatility of an asset (currency pair, stock, or commodity) price is simply how much it fluctuates with no regard to direction. It is given as a percentage of the asset price. A higher volatility means the price has moved or is expected to move over a larger range in a set time period.

Historical volatility is the volatility of the underlying price over some period in the past. Future volatility is the volatility of the underlying price over some period in the future. The price of an option depends on future volatility, yet it is impossible for anyone to know exact future volatility! However, it is possible to calculate the marketplace’s expected future volatility using the option’s price itself. This is known as implied volatility (IV) and, due to the nature of its calculation, it is theoretical. If IV is high, it means the market thinks the price has potential for large movement in either direction. Low IV implies the market thinks the price will not move much.

When the implied volatility (IV) of an option is 5%, what does it mean?

It means, theoretically, the market is expecting the price to move by 5%, either up or down, over a certain time period. If EUR/USD is trading at 1.3500 and the IV of a 1 year option is 5%, it means the market expects the price of EUR/USD to move either 5% above or below its current value in the next year in a range from 1.2825 to 1.4175.

Options with a higher IV cost more. This is intuitive due to the higher likelihood of the market ‘swinging’ in your favour. If IV increases and you are holding an option, this is good. Unfortunately, if you have sold an option, it is bad. A seller wants IV to fall so the premium falls. You should also note short-dated options are less sensitive to IV, while long-dated are more sensitive.

You can trade the IV value by monitoring an IV chart for a specific underlying market for a certain time period and determine the IV range. The peaks suggest the option is expensive to buy and the troughs suggest the option is inexpensive. This information can be used when deciding which options to buy or sell. It is important to note you cannot compare the IV values of different options, for example a EUR/USD option with a 1 week expiry will have a different IV to a EUR/USD option with a 1 month expiry.

Vega

Vega is the sensitivity of an option’s value to a change in volatility. It is usually expressed as the change in premium value per 1% change in implied volatility.

If the Vega of a long (buy) option position is 75 USD and IV increases or decreases by 1%, the option’s premium will increase or decrease by 75 USD, respectively. The Vega of a short (sell) option position is negative and an increasing IV is bad.

Example

Volatility now = 25%

Option’s premium value = $1000 Vega = $100

Volatility Option’s value*

23% $800

24% $900

25% $1000

26% $1100

27% $1200

*As long as all other parameters remain the same.

Vega is generally larger in options which have longer time until expiry, and it falls as the option approaches expiry. This is because an increase in IV is more beneficial for a longer term option than for an option that will expire in the next 10 minutes.

The Vega is at its maximum when the option is ATM and declines exponentially as the option moves ITM or OTM. This is because a small change in IV will make no difference on the likelihood of an option far out-of-the-money expiring ITM or on the likelihood of an option far into-the-money not expiring ITM. ATM options are far more sensitive since higher IV greatly increases their chances of expiring ITM.

How to trade it: If you buy a long-dated, slightly OTM option and your choice of market direction is right, such that the option moves towards ATM, then the Vega will boost your premium.

The below ‘shark-fin’ chart shows the behaviour of the Vega as the option moves from ITM to ATM to OTM and as it gets closer to expiry.

 

The third factor affecting Vega is the level of IV itself. A higher IV tends to make OTM options more attractive since it means the option is more likely to expire ITM. Consequently, when IV is higher, the Vega, in general, is also higher.

Theta

Theta is the sensitivity of an option’s value to the passage of time. It is usually expressed as the change in value per one day’s passage of time.

Example

Option’s premium value at execution= $1000 Theta = -$20

Passage of time Option’s value*

0 days $1000

+ 1 day $980

+2 days $960

+3 days $940

*As long as all other parameters remain the same.

For a buy (long) option position, Theta is negative and for a sell (short) option position, Theta is positive; time decay is bad for a buyer, good for a seller. In the platform’s Sensitivity table, Theta is given as an amount in the traded pair’s secondary currency.

Theta is not a constant, it changes as the underlying market moves and time passes.

The Theta of ATM options is higher and as time draws nearer to expiry, it increases. If you are holding an ATM option and expiry is approaching, you might be better off closing out of your position.

How to trade it: Option sellers can reap the benefits of a high Theta near expiry by selling short-dated ATM options with the expectation of little to almost no market movement.

For ITM and OTM options as time to expiry draws nearer, Theta lowers and decreases. The chart below is an example of how Theta behaves when the option is ITM, ATM, and OTM, and as time passes. You can also observe the dramatic impact of time decay (Theta) for an ATM option approaching expiry.

 

Rho

Rho is the least important Greek. However, it is worth mentioning.

Rho measures the sensitivity of an option to a change in interest rates. For example, if a Call option has a Rho of +9.52 for every 1% increase in interest rate, the value of the option will increase by 9.52%.

For currency pairs, it is related to the forward rate. The larger the interest rate difference between the two currencies, the more forward points you either pay or receive. Time period also influences the forward points. If the forward rate is over a longer period, then the forward point change will be larger since interest has more affect over a longer time.

It is similar with the Rho of an option. Over a longer time period and with a larger difference in interest rates of the two currencies, the absolute value of Rho is greater.

If the base currency of the traded pair’s interest rate increases, then a Call option’s value will increase since you hold the right to buy the currency. However, a Put option’s value will decrease because you’re trading the right to sell. Hence, Rho is positive for a buy (long) Call and negative for a buy (long) Put. However, interest rates rarely change drastically, so Rho has the least impact on option pricing.

Combining the Powers of the Greeks

The table below gives you an overview of different options with respect to the Greeks. It will help you to decide which option to use when trading your market expectation and how to manage your open option position.

  • OTM options are always the cheapest options hence buyers pay less and sellers receive less. They rely solely on extrinsic value and have a low Delta, Theta, and Vega. A move towards the ATM territory increases the Vega, Gamma and Delta which boosts premium. However, Theta (time decay) also increases especially as expiry approaches.
  • ATM options are more expensive than OTM options, but cheaper than ITM options. They have the highest Gamma, Vega, and Theta which means their premium is the most sensitive to moves in either direction. They are particularly sensitive to Theta as time to expiry approaches. The Delta of ATM options are 50%, which means there is an even likelihood of expiring ITM or OTM.
  • ITM options are the most expensive. Thus, buyers pay the most and sellers receive the most. Their premium is mostly made up of intrinsic value so they are relatively immune to Vega and Theta. Hence, trade an ITM option if you want to minimise the risk of Vega and Theta. They are an excellent tool when you have a strong view on the market because deep ITM options have the highest Delta. They will behave more like a position in the underlying. But if the market moves against you, the Delta declines so the loss becomes smaller. As expiry approaches, the Delta increases.

 

  • Higher Delta (absolute value) => Option is more valuable. Good for the buyer, bad for the seller.
  • Higher Gamma => Option is more sensitive to moves in the underlying market. Increases the risk and reward for both option buyers and sellers.
  • Higher Vega => Option is more sensitive to changes in the underlying market’s volatility. Increases the risk and reward for both option buyers and sellers.
  • Higher Theta => Option decays at a faster rate. Bad for the buyer, good for the seller