Trading Forex via Vanilla Options

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The term “vanilla” when applied to options means simple or at least less complex or “exotic” than other types of options trading. In other words, vanilla options trading is plain puts and calls. A call is the right to buy a specific amount of the currency at a named strike price on or before a specific date, and a put is the right to sell a specific amount of the currency at a named strike price on or before a specific date. In Forex, options can be exchange-traded (in futures) or over-the-counter (in retail spot Forex).

As a general rule, “European” options can be exercised only on the expiration date, while “American” options can be exercised on any date before expiration as well as on the expiration date.

A full understanding of option pricing requires advanced math, but in a nutshell, option pricing is a function of:

  • Today’s price
  • The strike price (higher or lower than the current price)
  • The time to expiration
  • Expected volatility of the security over the life of the option

“Intrinsic value” is what the option contract would be worth today and is a function of the difference between the current price and the strike price:

  • If the strike is higher than the current price, the option is "in the money."
  • If the strike is the current price, the option is “at the money.”
  • If the strike is lower than the current price, the option is "out of the money."

It is self-evident that if you buy a call (the right to buy) at a strike price that is the same or higher than today’s price, the cost or premium you will pay will include the difference representing the gain as well as time value and volatility considerations.

Vanilla options can be traded in their own right as a directional bet or as a hedge against an existing position. Options can be a less expensive way to make a bet, and if designed properly, reduce the risk of loss. In essence, the very word “option” suggests that the buyer has the right but not the obligation to complete a trade at a specific price and time, but this can be misleading — if you are the seller (writer) of an option, you cannot opt out and must deliver to the counterparty if the option he bought from you is profitable. When you are an option buyer, the most you can lose is the premium you paid. When you are an option seller, theoretically your loss is unlimited. In Forex in practice, losses are not really unlimited — currencies do not go out of business like companies’ equities may — but losses can be extremely large, especially if leverage is applied.

Basic Options

Buying Calls

You buy a call if you think that currency will go up, setting the strike price at a reasonable level that may well get reached over the time period of the option. If the price goes up by more than the premium you pay, you get to pocket the difference. If the price fails to get near the strike price or even goes the other way, you allow the option to expire worthless. Options traders always calculate their break-even price, i.e., the strike price plus or minus the cost of the option (premium).

Selling Calls

If you think the currency will fall, you can sell a call (also named “writing” a call), which from a position point of view, is the same thing as shorting the currency. As the seller, you earn the premium instead of paying it. As the currency falls, the gain begins to accumulate faster because of the presence of the already-earned premium. From a risk point of view, selling calls can be riskier than a plain short position (with a stop) because if the currency goes into a raging upside rally over the strike price, the loss can become very large very fast.

Buying Puts

If you believe the currency will fall, you will buy a put allowing you to “put” the contract amount to the buyer at expiration. If the price does indeed go below the breakeven (strike minus premium paid), you will exercise the option or sell it at the new profitable level. If the currency goes up instead of falling, you may sell your put, now worth less, or let it expire worthless.

Selling Puts

Selling puts, like selling calls, entails buying from the counterparty if the contract goes “in the money.” If the price at expiration is above the strike price, you still get to keep the premium.

Option Strategies

You can combine puts and calls to devise strategies that reflect your forecast of Forex market direction plus your estimation of the probability of being right or wrong. Option strategies can become complicated fast, since we have four types of vanilla options but a very large number of strike prices and premiums.

A straddle is among the simpler ones — you sell a put and a call at the same strike price. A strangle is different strike prices for the put and call. A butterfly spread entails buying one call at one price, selling two calls at a different strike, and buying another call at yet a third strike. The iron condor is like the butterfly spread but has two different strikes for the two short calls.

Hedging

In equities, a much-advertised strategy is to sell a covered call, i.e., sell a call at a high price when you already own the security. You set the strike price at a level of profit you would be glad to lock in. If the price falls instead of rising, you have earned the premium and that mitigates the loss somewhat. Most Forex traders do not hold long positions in currencies for long periods of time on the assumption of underlying value, but they may expect to be long a specific currency that is uptrending many times over the next one to three or even six months. These traders would sell calls on the currency farther out into the future than any single long position but they would still feel that they are “covered” most of the time.

Quiz:

1. If you buy options, you never lose more than the premium paid.

2. Out of the money options always cost less than at or in-the-money options.

3. Option strategies like the iron condor always entail selling as well as buying options and are therefore riskier.

Done