Understanding Currency Markets, Investing

Currency markets are fast becoming an attractive avenue for investors to make gains by betting on currency value fluctuations in a market that is open nearly 24 hours …

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Currency markets are fast becoming an attractive avenue for investors to make gains by betting on currency value fluctuations in a market that is open nearly 24 hours a day. The main thing that keeps many out of the market is a lack of understanding the mechanics of currency trading, particularly the use of futures and options. Options are bought and sold as rights to make purchases or sales of a thing in the future that allow investors to mitigate the risk found on in cash markets. Understanding these concepts can open up a new avenue of trading that can offer opportunities for profit not found in the traditional market. For more on this continue reading the following article from TheStreet.

Futures and options markets provide a method for the global exchange of goods and services in different currencies, allows producers to hedge forward contract costs, and offers speculators the chance to provide liquidity.

Futures contracts are used by international banks to balance capital reserves, multi-national companies to repatriate overseas profits, and inter-bank markets to create near-term lending liquidity. This creates a global market-place with high liquidity that is open virtually 24-hours a day in which futures programs can track the ebbs and flows of international trade across each regional time-zone.

Options and futures contracts are used to speculate in a particular market without all of the inherent risks that the cash market poses.

Traders who are only on one side of an option, or have no underlying asset to insure, are referred to as speculators. Producers of goods for future delivery that need to eliminate potential loss are referred to as hedgers.

Speculators and market makers provide liquidity to the hedgers, and in turn, the hedgers provide a reciprocal means by which both then have the opportunity to make profits.

Hedgers

If a client has entered into a long cash position that he or she plans to hold for a period of time to allow for maximum profit, or is producing a product to sell at a later date, he or she may also place a buy option puts or futures contracts in that same market, to hedge against a rash move down on their long position. The hedger may make up any loss sustained in the cash position by maximizing the premium of the long put he or she purchased.

The opposite side of the hedger’s contract position was provided by a speculator or a market maker. Each of these participants understand that the chances of the contract being in-the-money by expiration are low, but they each also understand the importance of the liquidity that was provided.

The nature of option and futures trades, and the job that they are designed to do, has a hedger expecting that their contract expires worthless. That means they made a profit on the long cash position, and paid the option or futures contract premium for peace of mind insurance.

The speculator or market maker on the other end of the trade would also hope for the same result, so they may realize the profit of their short option, and retain the premium paid by the hedger.

The Option Writer

The two ways of using options, one to speculate, and the other to hedge, offer an opportunity for traders who want to take opposite side of these types of trades.

Option writers hope to take advantage of the time value, which they know will decay every day until the option expires. They also know that a larger percentage of options expire worthless as opposed to being in the money. If calculated correctly, with enough equity for margin to hold on to short options, one can capitalize on these contracts.

A requisite of being an option writer is having enough equity in an account to use for margin. The option writer has an obligation to the option purchaser, which is to provide them the underlying position, upon request that the option be exercised, at the stated strike price, any time before the contract expires.

An option writer simply does not have any rights after shorting the market, other than closing his or her position. While they are in the position, everything is dictated by the movement of the market and the actions of the purchaser.

Shorting (or writing) options offers a limited profit in the amount of the premium paid by others, with unlimited risk. Purchasing an option offers limited risk of just the premium and fees paid, and unlimited profit potential.

Investors and traders who are not just day traders, but want to speculate on the underlying spot market, without dealing with the intra-day market swings, can purchase a call or put (given the direction: call to go up, put to go down) for a premium price.

This purchase gives them the right (but not the obligation) to buy (if a call) or sell (if a put) the underlying instrument at the contract’s stated strike price. If the market moves in the direction of the traders’ purchased strike price, then the option premium value will rise.

If the market surpasses the stated strike price, then the trader would, at the very least, be making the intrinsic value on that position (which is defined as the amount of points that the trade is "in-the-money") plus the value of the time remaining to expiration. If the option expires out of the money, then the contract is worthless and the trader has lost the premium they paid for the option.

Factors in Option Pricing

A key point about trading options is that the price of the option is derived from a few factors:

1) Intrinsic value: The amount of points that a strike price is "in-the-money".

Example: If the current market in EUR/USD is $1.4200. Then a $1.41 Call would be" in-the-money" by 100 pips, or have an intrinsic value of 100 pips.

The purchaser would have the right to exercise the option, resulting in a Long EUR/USD position at the price of $1.4100. That position can then be sold at the current 1.4200 price to realize the profit.

2) Time value: The value that a market maker gives to the remaining time before expiration, by factoring the volatility as well as the amount of days before option expires.

Example: The current market price of EUR/USD is $1.4200 and you own a $1.43 call with 10 days to expiration.

If the current price that the market maker is posting to buy that option is 20 pips, then the market maker is showing the time value associated with that strike price to be 20 pips.

The time value is what determines an out-of-the-money strike price value. As a rule, as time decays, so does the "time value" and by extension, so does the premium that a contract is worth.

If the underlying market price settles below the strike price of a Call, or above the strike price of a Put, then the options expire worthless, because it has no intrinsic value and, of course, no time value left.

Premium

To calculate the premium of an option, traders will use this formula:

Premium= Intrinsic value + Time value

In the above example, the premium is 20 pips and the intrinsic value is zero, because it is not "in-the- money" at all. This means the entire premium is time value.

Options pricing is usually derived from the Black & Scholes model of pricing.

An option’s delta is the percentage chance a particular strike price has to settle in the money by the stated expiration date. Delta is quoted as a percentage, not to exceed 100%. A strike with a .10 delta, has a 10% chance of being in the money, a strike with a .99 delta has a 99% chance.

Volatility is dictated and implied by the market maker who is pricing the option. This volatility is quoted as a percentage, and usually rises with expectations of a larger incremental move in the underlying instrument.

The rise in volatility will directly cause the rise of the premium that a particular strike price is quoted at. Conversely, a drop in volatility will directly cause the premium of the particular strike price to decrease.

Range-Bound Markets Entice Option Writers

Calls to go up, puts to go down: Over the course of the last two months, the currency markets have been mired in a fairly obvious trading range. With the range being held, traders who have become adept at finding different ways of capitalizing on this scenario are becoming more comfortable trading Currency options, in addition to their spot forex trading.

Strategies being employed during these range-bound periods usually involve the shorting (selling) of options, otherwise known as the shorting or selling of volatility. The combination of option time and market volatility, or uncertainty, gives value to options with strike prices that are out-of-the-money. There is no intrinsic value in the option price, the value is all in the time until expiry.

Buyers of options are those who purchase the instrument from the ones above who are selling (or writing). In range-bound markets, that may soon break, they are usually said to be buying time at a fairly cheap price. They are anticipating a volatile move, in both the market, and then by default the option itself, and that creates an anticipation that the trading range will get broken.

Traders will also buy options to hedge their primary spot (underlying) exposure, to replace the need for a stop-loss in the cash market. The spot position is covered by the option value increasing if things move against the cash price.

The option seller wants to receive a premium for the option that he or she is writing, which she or he deems worthless, as it has only time value because of being out-of-the-money, and therefore, the option writer is willing to sell time, especially in a range-bound market.

Currency Example

EUR/USD made highs of 1.4340, and then followed on by making lows of 1.3750 and trading in the same range without momentum.

Option writers want to capitalize on this range by straddling the EUR/USD market. They would short (sell) call options, with strike prices above the 1.4340 resistance, and short (sell) puts with strike prices below 1.3750.

This strategy is employed with anywhere from 25-30 day expiration, where time is still valued, even with odds of these strikes being hit at, or near, a paltry 10%.

That means that there is a 90% chance that the strike prices will not be reached within 25-30 days and the seller (or writer of the option) would keep the premium received for the risk in writing the short.

A trader with confidence and conviction of calling a range bound market will take that bet more times than not, the odds are actually stacked in the option writer’s favor. The ease with which options can be written, bought, and sold make for a fluid exchange, in a liquid commodity that has an exchange floor to monitor order flows and open interest.

Straddle Explanation: The channel is formed by the 1.4700 price on top, and the 1.3700 price below.

(Resistance) The 1.47 call option offers the right, but not the obligation, for the buyer to own a buy position at this price

(Cash/Spot Price) 1.42 current spot price EUR/USD

(Support) The 1.37 put option offers the right, but not the obligation, for the buyer to own a sell position at this price.

This article was republished with permission from TheStreet.

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