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ByJesús Martín Portillo

WHAT IS A FOREX OPTION AND HOW TRADE ON HIS EXPIRATION DATE?

WHAT IS A STOCK OPTION IN THE STOCK EXCHANGE MARKET?

Options are contracts established between a Broker and a Trader. The Broker grants the Trader the right to buy or sell a Stock at a specified time and price. In return, the Broker receives up front an economic compensation that is called Premium.

Therefore, a Sell Option is a contract, which grants the Trader, in accordance with the terms of the contract, the right to Sell the Stock, and a Buy Option is a contract that grants the Trader, in accordance with the terms of the contract, the right to Buy the Stock.

In this article, we are going to simply focus on the basic aspects that we need to know in order to predict the movements of a certain Stock, both in the moments before the expiration of options, and in the later moments.

The Trading strategy that we will explain below is simple and easy to understand and use, however, requires knowledge of the Long Term and Short-Term Market Stocks, as well as understanding and knowing the following concepts:

  • “Derivative Contract”: A derivative contract is a document, which reflects a contractual agreement on the evolution of an asset, called the underlying asset. There is a wide variety of derivative contracts on currencies, metals, commodities, indices, stocks, bonds, interest rates, etc.
  • “Strike Price”: It is the price value of the Stock from which the Trader subscribes a Buy Option, obtaining a Profit according to the type of Option contract. Analogously, it is the value of the price of the Stock from which the Trader that subscribes a Selling Option, obtaining a Profit according to the type of contract of the Option.
  • “Expiry date”: It is the date on which the contract is resolved, and payments are made. This data is undoubtedly crucial to consolidate our strategy.
  • “Option Size”: It is the payment stipulated in the Option contract to Trader that subscribes it.

WHAT IS AN OPTION ON THE FOREX MARKET?

An Option in the FOREX Market or Foreign Exchange Market, is a type of currency derivative contract that confers to its holder the right, but not the obligation, to carry out a currency transaction.

In general, the purchase of an Option in the FOREX Market, grants the right to a Trader to buy or sell a Pair of Currencies in a specific amount and / or on a specific date for an amount established in the Option contract. This right is granted by the seller of the Option, normally a Broker, in exchange for an upfront cost known as the Option premium.

In terms of its volume of operations, Currency Options currently represent 5% to 10% of the total volume of the Foreign Exchange Market.

TERMINOLOGY OF AN OPTION IN THE FOREX MARKET

Because the FOREX Market uses a specific terminology to define the elements and terms related to an Option, we have considered it appropriate to include the most used terms below.

  • “Exercise”: This is the act by which the Option buyer (Trader) communicates to the seller (Broker) that he intends to comply with the underlying currency contract of the Option.
  • “Expiration Date”: It is the last date from which the Option can be exercised.
  • “Delivery Date”: It is the date on which the currencies will be exchanged if the Option is exercised.
  • “Call Option”: It is the act by which the right to a Trader to buy a Pair of Currencies is conferred.
  • “Put Option”: It is the act by which the right to a Trader to sell a Pair of Currencies is conferred.
  • “Premium”: It is the initial cost that a Trader pays to a Broker to acquire an Option.
  • “Strike Price”: It is the price at which the currencies will be exchanged if the Trader decides to exercise the Option.
  • “Spot Price”: It is the current market value of a Stock at the time of quotation.

INFLUENCE FACTORS IN THE PRICE OF A FOREX OPTION

The cost of acquisition or Premium of a Currency Option depends on a large number of factors; however, it can be determined basically through the following factors:

  • Strike Price,
  • Expiration date,
  • Type or Style of Option,
  • The currency that the result will be paid, regardless of whether it is a Put Option or a Call Option,
  • Spot Price on the date of contract the Option,
  • Inter-bank deposit rates for each of the currencies that make up the Currency Pair,
  • Volatility level estimated at the due date. The Options Market implicitly involves the concept of volatility and this is measured through the value of the annualized standard deviation of the exchange rate movements of the Currency Pair expected by the market during the useful life of the Option. The Options Market Makers estimate this key factor and, in general, they express it in percentage terms.

We must always bear in mind the following Golden Rule of Options:We must always Buy Options when volatility is low and Sell Options when volatility is high.”

STYLES AND TYPES OF EXECUTION OF A FOREX OPTION

The Currency Pair Options present (2) two basic styles that differ according to the moment in which the holder can choose their execution date. These different styles are the European Style and the American Style.

The most common style of Foreign Currency Options traded on the OTC market is the European Style. This style of Option can only be exercised on its expiration date up to a certain specific cut-off time, generally at the opening time of the Market in Tokyo, London or New York.

However, the most common style for currency futures options, such as those traded on the Chicago IMM stock exchange, is known as the American Style. This option style can be exercised at any time up to and including its expiration date. This flexibility of the American Style options entails a higher value of Premium in relation to the European Style options.

Among the different types of Options, the most frequent are the Vanilla Options, are the classic options par excellence.

EXAMPLES OF VANILLA OPTIONS

Suppose that the Currency Pair EUR / USD is today at a quoted price of 1.1234, that is to say the change of the Pair of Currencies is 1.1234 Dollars per Euro. Consider that the EUR / USD pair has an upward trend for the next month and we decided to acquire 10000 purchase options (CALL) for a premium of 5$ and agreeing to an exercise price of 1.1500$, which means that if next month we exercise the option we will pay 1.1500$ for each Option. Which means that if we exercise the Option we will have invested:

Investment=5$+10000 x 1.1500$=11505$

At the expiration date we can find 3 different situations:

  1. The Currencies Pair is quoted well below the exercise price of 1.1500$: In this case we will not exercise the purchase option and we will lose what was paid for the premium, i.e. 5$.
  2. The price is between 1.1450$ and  1500$: In this case we must assess whether we exercise or not exercise the option because if the price continues to rise we will reduce the loss of  55$ to  5$ and we can even win the operation However, if the price goes down we will lose even more money.

Result 1=10000$ x 1.1450$- 11505$= -55$

Result 2=10000$ x 1.1500$- 11505$= -5$

  1. . The price is above 1.1505 $: In this case we will always exercise the option since we will obtain benefits. For example, if at the time of exercise of the option the Currency Pair quotes 1.1605$, we will be obtaining a benefit of:

Result 3=10000$ x 1.1605$- 11505$= 100$

Let’s repeat the previous example but now with a 10000 put options (PUT) for a premium of  5$ and agreeing a strike price of 1.0800$, which means that if we exercise the option next month, we will pay 1.0800$ for each Option. Which means that if we exercise the Option we will have invested:

Investment=5$+10000 x 1.0800$=10805$

At the expiration date we can find 3 different situations:

  1. The Currency Pair is quoted at a price well above the exercise price of 1.0800$: In this case we will not exercise the purchase option and we will lose what was paid for the premium, i.e. 5$.
  2. The price is between 1.0750$ and 1.0800$: In this case we must assess whether we exercise or not exercise the option because if the price continues to fall we will reduce the loss of 55$ to 5$ and we can even win the operation However, if the price goes up, we will lose even more money.

Result 1=10000$ x 1.0750$- 10805$= -55$

Result 2=10000$ x 1.0800$- 10805$= -5$

  1. The price is below 1.0800$: In this case we will always exercise the option since we will obtain benefits. For example, if at the time of exercise of the option the Currency Pair quotes at 1.0705$, we will be obtaining a benefit of:

Result 3=10000$ x 1.0705$- 10805$= 100$

HOW TO TRADE THE EXPIRATION DATE OF A FOREX OPTION

Many traders sometimes face situations in the FOREX Market that they are not able to understand or explain. This effect increases during the periods in which significant fundamental data are not presented to affect the price and yet there are spikes by surprise in the movement of the price, which very few understand its nature and that many misidentify Market Traps.

Always remember that in the market there are no traps, everything has its explanation and that we are not able to understand the movement of the price of a stock, does not mean that the stock is manipulated. It does not escape anyone that the decision in any company as in the Market, is taken by the majority shareholders and not by the minority shareholders.

The ideal conditions for trading currencies at moments close to the expiration of the Option are the following:

  • Option expiry is at 10 am EST.
  • Option size is greater than 500 million USD.
  • The Currency Pair price is close to the Strike Price before the news release at 8:30 a.m. EST.
  • The Fundamental Data press release is not an important event, such as a Fed decision that changes the economic outlook.

But even without the presentation of these conditions, considerable gains can be made with this method in a quiet market without excitement. However, we must bear in mind that these ideal conditions, together with the importance of the press release, are the main determinants of the mood of the mass of traders that, in turn, will influence our strategy and our potential profit.

Data on Currency Options contracts that are close to expiry is regularly provided by IFR Thomson Reuters and distributed by different Brokers that offer this service. CME Group also provide this information. https://www.cmegroup.com/

The origin of these movements is very simple and is based on the principle on which the Options are based. When a Broker or a “Market Maker” through a Broker sells an Option to a Trader, it charges a Premium up front and assumes the obligation to pay the holder of the Option in this case the Trader, if the operation is executed with benefits and the obligation to have to bear losses if the operation is not executed..

On the one hand, taking into account that the number of Consistent Traders is very low around 5% of the total, that most of the Traders are not Consistent and operate by sentiment in 95% of the cases, we can conclude that the majority of the Options will end up in loss, reason why, the level of risk acquired by the Broker is very high.

On the other hand, we have the effect called Defense of the Option. Both the Broker and the Traders will try to defend their positions and for that they will increase their volume of operations until they reach their goal.

In order to clearly understand this effect, we are going to give you an example. Let us suppose that the current price of the Currency Pair EUR/USD is 1.12335 and that within 2 hours they expire 3 billion in Purchase Options at the level of the Price of Execution of 1.13200. The price will start to move suddenly upwards through strong expansions trying to reach the Execution Level.

Once this level has been reached, the price will rise through a new expansion between 20 Pips and 30 Pips more until the time of execution of the Option. After the executions of the options, the Price will try to reach the previous lower levels, although generally the price will remain around the 50% retracement of the previous expansion.

These Windows of Opportunity allow us in Call Options to open Buy operations in the Expansions and close them in the Contractions of each movement. The expiration of Put Options works analogously and its use is similar to that described above. In this case our tickets will be for Sell in the generated Opportunity Windows.

CONCLUSIONS

The options in the FOREX Market help Traders to understand the movements of the Currency Pairs with greater clarity and even offer the possibility of accessing Windows of Opportunity. However, as we explained in the Master of Professional Trading, this effect can be quickly diluted before any Fundamental data or important political event that affects the FOREX Market in a more significant way.

 

 

ByJesús Martín Portillo

WHAT IS MARKET NOISE AND HOW DOES IT AFFECT OUR TRADING PROCESS?

To understand the concept of Market Noise we have to understand beforehand that the Trading Process is the fight at all times between the Traders that open a BUY position because they think that the future Trend is going to be Bullish and the Traders that open a position of SELL because they think that the future Trend is going to be bearish. The result of this fight or difference between the Buy Volumes and the Sell Volumes is who determines in the first instance the resulting Trend.

In addition, there are external factors that undoubtedly condition our Decision Process and sometimes make us position ourselves in the Bulls side and other times that we position ourselves in the Bear side.

Bulls and Bears in the Market, has its origin in the form in which these animals attack. Bulls attack from the bottom up, in a bullish manner. On the contrary, the Bears attack from top to bottom, in a bearish manner.

Among the external factors that affect our Decision Process, perhaps the most important is the Manipulation of Information. Manipulation Information has two distinct and complementary meanings. The first meaning refers to the process of data collection, analysis of data, establishment of conclusions, generation of information and disclosure. This means that our analysis and conclusions are not partisan and are based exclusively on data and objective evaluation criteria. However, the reality is quite another and from there the second meaning is born.

The second meaning refers to the application of a series of related techniques with which members of a certain group create an image or an idea that favors their particular interests or those of their clients.

On numerous occasions, a Trader finds that in economic information channels on television or on Internet a promising upward future of a certain Stock is predicted.

However, immediately afterwards usually there is a sharp fall in the value of the Stock and vice versa. Once this happens the media that spread the previous news immediately find hundreds of reasons to explain why the price of the stock has evolved contrary to the information initially provided.

It is clear that the Institutional Investors or Market Makers have no interest in Traders Professionals follow his steps and for this reason they use any tactic that is in their hands to avoid it and obviously are aware that misinformation is equivalent to throw a torpedo at the Flotation Line of the Professional Trader’s Decision Process.

This does not mean that we should not be informed. What this means is that while a data obtained from an Official Publication can not be manipulated, the information on the contrary is susceptible to being manipulated. For this reason, we must be very careful when analyzing the truthfulness and real impact of any information in the Market, since it can very negatively affect our Decision Process.

In short, this struggle between Decision Processes between Bullish Traders and Bearish Traders is what causes and generates Market Noise and is what usually causes many Traders to make mistakes in their Decision Process. Likewise, the Market Noise is responsible for the characteristic shape of the curve in the shape of a sawtooth that represents the Movement of the Price of any Stock in the Market.

DOES THE MARKET NOISE AFFECT OUR TRADING PROCESS?

Undoubtedly Market Noise affects our Decision Process and therefore affects our Trading Process in a negative way as it prevents us from seeing clearly what the future Trend of the movement of any Market Stock may be.

 

 

In short, what Market Noise does is to blur reality by camouflaging the Real Tendency so that we cannot correctly discern what it is. Which forces us to take measures to mitigate Market Noise, since what is evident is that it cannot be eliminated 100%.

WHAT MEASURES SHOULD WE TAKE TO MITIGATE THE MARKET NOISE?

Let’s see how and how we should analyze the Price Movement of any Stock in the Market to mitigate the effect of Market Noise:

  1. i. The Moving Averages reduce and significantly mitigate Market Noise. For this reason, I recommend that you use three (3) Moving Averages of periods fourteen (14), twenty (20) and forty (40) so that when the crossing occurs, we are informed clearly and with maximum probability of the exchange points. of Trend of the Price Movement.
  2. We must never analyze the Price Movement in a Temporal Framework of one (1) minute or in a Temporal Framework of five (5) minutes to determine the Real Trend.
  3. We must analyze the Price Movement in a Temporal Framework of one (1) day to determine the Real Trend. For this we will draw the Stock Price Movement Channel and draw the Horizontal Lines of Resistance and Support Levels.
  4. We will repeat the previous operation in a Temporal Framework of four (4) hours and determine the Trend. If both trends coincide, it means that there is a maximum probability that the Stock price will continue its movement in accordance with the Real Trend. Therefore, we will only open operations based on the Real Trend if our Trading Style is Swing Trading.
  5. Once the Real Tendency is analyzed, we will determine the Secondary Tendency in the Temporal Framework of one (1) hour. And for this we repeat again the previously defined process. Remember that the Real Tendency and the Secondary Tendency do not have to coincide. Once the Secondary Trend is determined, we will only open operations based on the Secondary Trend if our Trading Style is Scalping.
  6. Avoid opening operations at times when there is a lot of volatility or at moments close to the publication of Fundamental Stock Data since the reaction of the mass of Traders to a good data or to a bad data is often unpredictable.

CONCLUSIONS

Success in the Trading Process is not based on magic formulas, nor on what a Guru or Specialized Media think that will do the price tomorrow. No one knows what the price will do. Our success as Professional Traders is only based on a Strict Discipline and adequate Technical and Psychological Training. Remember to achieve Consistency is not an easy and simple task, it requires a lot of time and effort.

For all this one of the fundamental concepts that we must master to achieve Consistency is precisely to know how to mitigate the effect of Market Noise in the Trading Process and I sincerely hope that the concepts that we have presented in this article serve to improve your Decision Process and ultimately your Trading Process.

ByJesús Martín Portillo

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