Title : Risk from Forex using Options
There are many excellent texts (e.g. Option Volatility and Pricing by Natenburg) explaining the theory of options and we will only give an abbreviated review. In a nutshell, an option is the right but not the obligation to purchase (call) or sell (put) the underlying at a certain price (strike price). The cost of that right (the purchase price of the option) is called the premium. Options have an expiry date, beyond which they cannot be exercised. The premium consists of the intrinsic value and the time value (e.g., the more in the money it is, and the more distant expiry, the more valuable). Another important element in option pricing is volatility. The higher the implied volatility (and therefore probability of the option ending in-the-money (ITM), the higher the premium will be. The topic of option pricing is very complex, and it was only after Black-Scholes-Merton (BSM) created their model that option pricing gained objectivity (if not accuracy- there are many unrealistic assumptions in their model). The BSM model uses 5 main variables which they named from the Greek alphabet- three of which are very important: Delta- how the option value changes as the underlying Gamma- the first derivative, or velocity, of Delta Theta- how fast the option loses value with time, Vega- what effect a change in the underlying volatility affects the option value, Rho- interest rate effects) is less important to traders, having only a second degree effect on option value. In the simplest case, if we were to purchase a call with a strike above the current spot price, and the spot rises above his strike before expiration, we will be profitable. Similarly, if we purchase a put and the spot falls below the strike before expiry, we will be profitable. We can collect his profits by either waiting until expiry and exercising the right, or selling the option before expiry. While we can be either net long options (i.e., we can buy calls and puts) or short (sell calls and puts), a common theme amongst successful investors is to never be net Forex using short options (ie, never negative gamma), as the risk rises infinitely. If we are always net long options (this means you are purchasing calls and puts), the risk is always only the premium- what Forex using we paid for the option. The position may be closed ITM worth many multiples of the premium, but in the Forex using worst case, with the option expiring OTM (out-of-the-money), the value of the option can never drop below zero. If we are a net seller of options (i.e. short gamma), we have unlimited downside risks. Chart 5 Here is an example of a bullish position, comparing Forex using the underlying and a call with a strike of 60 and premium of $2. Note four important things (three of Forex using which we can see). 1) Playing the underlying becomes more profitable sooner (by the Forex using amount of the premium paid for the option.), if the Forex using direction is -25 correct.