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John L. Person - Forex Conquered. High Probability Systems and Strategies for Active Traders, Wiley | ||||
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free download links about online stock trading, forex, futures, stock investing, market, trading systems One of the best features of the futures markets is that they have listed options; and because these are futures products, they also have the access of the transparency on how many options on the futures contracts are avail able to buy and how many options on the futures contracts are offered to sell. This book, Forex Conquered, is designed to give you specific trading plans on all aspects of foreign currency trading opportunities. I feel that there are many, many choices; and yet so few people are aware of them. Options are just one futures trading vehicle, and many forex traders have had only limited exposure to options. Therefore, I want to introduce you to what they are and how you can benefit from them in your trading career. To start with, there are two types of options: a call and a put. And there are two kinds of positions for each call and put: a buyer and a seller, or an op tion writer. A buyer or long option holder of a call has the right but not the obliga tion to be long a futures position at a specific price level, for a specific pe riod of time and for a specific price called the premium. A buyer or long option holder of a put has the right but not the obligation to be short a fu tures position for a specific price that is paid by the buyer at a specific price level and for a specific period of time. For option buyers, the premium is a nonrefundable payment, unlike a margin requirement for a futures contract where it is a good-faith deposit. Premium values are subject to constant changes as dictated by market conditions and other variables, such as time decay and the distance between the underlying value of the market and the strike price of the option. One more factor that determines an options value is the volatility rate, which is based on price fluctuations in the activity on the underlying futures market. The wider and faster the price movements are, the higher the volatility level is; and a higher volatility rate will help in crease the options value. There are other variables that are used to calculate an options value, such as interest rates and demand for the options itself. For instance, if you bought a call option and if the underlying futures market is moving up toward your strike price, then the option's premium value may increase, be cause option writers or sellers will want more money and buyers will have to pay more for the premium of the option. This is an example of an in crease in demand for the option as a direct result of the market's expecta tion of the movement in the price direction. One of the first things to know about buying options in futures is that you do not need to hold them until expiration. Option buyers may sell their position at any time during market hours when the contracts are trading on the exchange. Options may be exercised at any time before the expiration date during regular market hours by notifying the broker. Usually one ex ercises in-the-money options; this is called the American style of option ex ercising. It is called the European style of option exercising when the option can only be exercised on the day the option expires. A seller or option writer of a call or put grants the option buyer the rights conveyed from that option. The seller receives a price that is paid by the buyer, that is, the premium. Sellers have no rights to that specific op tion except that they receive the premium for the transaction and are ob ligated to deliver the futures position as assigned according to the terms of the option. A seller can cover his or her position by buying back the option or by spreading off the risk in other options or in the underlying futures market if market conditions permit. A buyer of an option has the right to either off set the long option or exercise his option at any time during the life of the option. When a trader exercises his option, it gives the buyer the specific position (long for calls and short for puts) in the underlying futures con tract at the specific price level as determined by the strike price. Options are generally exercised when they are in the money (ITM)—the strike price is below the futures price for a call option and above the futures price for a put option There are three major factors that determine an option's value, otherwise known as the premium. 1. Time value—the difference between the time you enter the option po sition and the life the option holds until expiration. An option that has more time value is worth more than an option that is soon to expire, all things being equal. The term wasting asset is applied to an option be cause the closer the time comes to the option's expiration, the less the option is worth. 2. Intrinsic value—the distance between the strike price of the option and the difference to the underlying derivative contract. If an option's strike price is closer to the underlying futures contract, it will be more expensive than an option that is further away. The term used is a call option, which gives the buyer the right, not the obligation, to be long the market. A call option will cost more if the strike price is closer to the actual futures price. The reverse is true for put options. A put op tion will be more expensive if it is closer to the derivitive market price. These two examples are considered to be out of the money (OTM), be cause neither is worth exericising. (An in-the-money option is referred to when the strike price is below the futures for a call option and above the futures for a put option.) 3. Volatility—the measure of historical price changes. Volatility accounts for the pace of price change. In periods of violent price moves, options will command high premium values. Volatility is calculated by the mag nitude of a market's past price move and current market condition. Let's review some examples and at the same time help review what we have covered as forex and futures relate to each other. Keep in mind that the value of a futures contract is $125,000 worth of euros, the initial margin requirement as of August 29, 2006 , is $2,835, and the maintenance margin is $2,100. These are subject to change without notice and are set by the indi vidual exchanges. Option Strategy Exercise On August 29, 2006 , at 12:00 P . M . (EST), the forex spot euro currency was at 127.67. At that precise moment, the December futures contract was at 128.49. Reference the basis, which is the price difference between where the spot market is valued and where the futures price is traded. That difference is 0.82 points. The 130.00 strike price for the December euro cur rency call option, which expires on December 8, 2006 , has a shelf life of 101 days until it expires. The premium was quoted at 1.67 points. Each point is worth $12.50, so the value or cost of that option would be $2,087.50. At expiration, the December futures contract price would converge to represent what the spot forex market price would be. The basis would narrow as futures becomes the cash market. For you to just break even, as this was an out-of-the-money call option at expi ration, the spot and futures markets would need to be at 131.67. That is the point value of the premium added to the strike price of the option (130.00 + 1.67 = 131.67). That's the bad news. The good news is that if the market price moved within the first 30 days after you purchase the out-of-the money call option, then the value would theoretically increase by 0.17 per cent, which was determined by the “delta,” one of what is called the “Greeks.” It is a calculation that helps options traders to determine prices for option premiums. By the same token, an out-of-the-money put option with a strike price of 125.00 was valued at 85 points or $1,062.50 (85 ? 12.5 = $1,062.50). The 125.00 put option was out of the money by 349 points (125.00 - 128.49 = 3.49). Applying the Strategy First, if you are outright bullish on the euro and thought the dollar would decline to new all-time lows, the best strategy for unlimited rewards and limited risk would simply be to buy a long-term call option, which in the ex ample using the 130 December strike would be less money and defined risk to the premium you paid, $2,087.50. Second, if you thought the dollar would rally and the euro would decline with the same risk/reward parameters, then using the OTM 125 put option would be a good consideration because your maximum risk would be the premium you paid, $1,062.50. There are many combinations of option plays with various names, such as “strangles and straddles.” Using options allows you a whole new world of opportunities other than long/short outlooks in a specific time frame. Table 1.2 shows the spread between the strikes and the actual cash or spot market; they are roughly equal to each other, with the call at a 233-point spread difference to the spot and the put at a 267-point-spread difference to the spot. Only the futures markets has the big point spread difference; and remember, as we get closer to expiration, the futures becomes the cash market, and the basis narrows with time. Therefore, another strategy called a strangle would be, if you thought the price of the euro was going to stay in a range between 125 and 130, to sell (or write) both the call and the put options. This way you would receive the premium of both the call and the put. You would have changed your risk parameters because writing op tions have limited profit potential with unlimited risks and your margin requirements would increase as well. Pricing Options If you had no clue which way the market would move but felt there was going to be a massive breakout one way or another, particularly in the time horizon of the three-month shelf life of the December option, then employ ing what is called a straddle would limit your risks while allowing you to participate. A straddle occurs when you buy the 130 call and the 125 put. In this case, you would need to pay out $3,150.00, which is the amount of the two premiums. Keep in mind that your breakeven at expiration would be 132.52 on the upside and 122.48 on the downside. So at expiration, anything above or below those levels would start to accrue profits. In the Money Using the same variables as in the preceding example, a 125.00 call option would be considered in the money since the futures market was at 128.49. This call option has an intrinsic value that is the difference between the strike price and the underlying market of 349 points (125.00 - 128.49 = 3.49). That leaves a balance of 94 points given for the time premium value. Notice that the 130 call option was entirely out of the money and has more time premium value built into the option. Sometimes it pays to buy in-the money options versus out-of-the-money options. Collar, Not Choke, the Market For a dollar bear or a euro bull, here is one of my favorite option strategies. It is a hedge strategy using both options and the underlying market, which under the right circumstances can work very effectively as far as risk-to-reward ratios and money management tactics are concerned. The opposite position can be implemented as well if you are bullish the U.S. dollar and bearish the euro. Let's examine a bullish collar strategy for longer-term traders. This strategy allows you to participate in a limited move with lim ited risk and still lets you sleep at night. If you trade the spot forex market, you will need two accounts: a forex account and a futures account. Forex traders who take a long position in the spot euro currency market with a full $100,000 lot size position will need to add $25,000 worth of mini lots to be equal in capitalization size with one futures contract. First, you want to enter the options side by selling the 130 call option and then buying the 125 put option. Once your order is filled, then enter the long position. You will collect premium from the short call option, which you will use to finance the put option. You are collecting more premiums from the call side and will have a credit, as Table 1.3 shows. Also keep in mind that this is not an equally weighted position due to the basis difference between the spot and the futures markets; but as time passes, remember that the futures will line up with the spot market. If you are long the spot euro at 127.67, keep in mind that the futures market was at 128.49. But as you know, on any given day, generally both the cash and the futures will move in tandem, with a gradual decay in the futures mar ket's basis. The key here is that you have protection to the downside calculated at expiration of 185 points; your maximum reward is 315 points. This is close to a one-to-two risk/reward ratio. In order to make the collar strategy worth executing, you generally want to collect a premium or get a credit on the strategy or, at the very least, not pay out-of-pocket money on the options side. Since these are op tions on a futures contract, you will be charged a commission; therefore, you will need to check rates and margin requirements with different futures brokers. Futures brokers cannot lower the margin that the exchange sets, but they can increase the amount. So you need to do your homework. As far as options are concerned, they do have great benefits from the aspect of simple speculating on a directional price move to the use and application as an insurance vehicle, which is what we refer to as a hedge. As a foreign cur rency trader, certainly expanding your knowledge of these features and benefits can enhance your trading opportunities on various time frames, especially longer-term horizons. Using options to hedge positions into long holiday weekends, before government reports (such as the monthly unem ployment number), or before Federal Open Market Committee (FOMC) meetings can help protect your account during violent adverse price moves, especially when they are short-lived. It is one aspect of trading with which all traders and investors should become more familiar. |
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