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:
- The Currencies Pair is quoted well below the exercise price of 1.1500$: In this case we will not exercise the purchase option and we will lose what was paid for the premium, i.e. 5$.
- 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$
- . 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:
- The Currency Pair is quoted at a price well above the exercise price of 1.0800$: In this case we will not exercise the purchase option and we will lose what was paid for the premium, i.e. 5$.
- 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$
- 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.
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.