FX Options Trading Class 1

Gregory McDermott, MApp Fin OU Chief FX Strategist

 U.S. Government Required Disclaimer Foreign Exchange trading has large potential rewards, but also large potential risk. You must be aware of the risks and be willing to accept them in order to invest in the fx markets. Don't trade with money you can't afford to lose. This website is neither a solicitation nor an offer to Buy/Sell options. No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed on this website. The past performance of any trading system or methodology is not necessarily indicative of future results.

WCO Currency Pairs

HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT BEEN EXECUTED, THE RESULTS MAY HAVE UNDER-OR-OVER COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFIT OR LOSSES SIMILAR TO THOSE SHOWN.

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FX Options Trading Course 8 Nights

August 18 20 (Mon-Wed) 9pm Eastern August 25 28 (Mon-Wed) 9pm Eastern September 2 - 3 (TuesWed) 9pm Eastern Bonus Free FX Class The Best Time To Trade Forex Thursday Sept 4, 2008 9pm Eastern

Lets Hear From You!

Raise your hand.
I will activate your mike.

Please keep you question on the subject. I reserve the right to end the practice if it slows or disrupts the learning for the class.

The Language of Foreign Exchange

Currency Pairs Pips Bid Offer Spreads Order Types

Currency Pairs
Currency Abbreviations
USD GBP EUR JPY CAN AUD CHF US Dollar British Pound Euro Japanese Yen Canadian Dollar Australian Dollar Swiss Franc

Currency Pairs
The Exchange Rate of a Currency Pair is the Number of Units of the Counter Currency that 1 Unit of the Base Currency can purchase.

Currency Pairs
GBP/USD
Base Currency 1st Currency in the Pair Currency is Bought Counter Currency 2nd Currency in the Pair Currency is Sold or Borrowed A Currency Pair Always represents a simultaneous sale and purchase of 2 currencies

Currency Pairs
You already use exchange rates everyday.
Purchase 1 Gallon of Gasoline @ $US 4.00 You Exchange/Sell $US 4.00 & Buy 1 gallon of gasoline What is your base currency?
Gasoline

What is your counter currency?

USD

Gasoline/USD = $US 4.00

Currency Pairs
GBP/USD
Base Currency? GBP Counter Currency? USD

USD/JPY
Base Currency? USD Counter Currency? JPY

Currency Pairs
Example
GBP/USD = 1.8750
What is the Base Currency? GBP What is the Counter Currency? USD What does this quote tell us? $US 1.8750 = 1.0000 GBP

Currency Pairs
Example
USD/GBP = .5333
What is the Base Currency? USD What is the Counter Currency? GBP What does this quote tell us? 0.5333 GBP = 1.0000 USD

Currency Pairs
The 2 Ways to Quote a Currency Pair have a Mathematical Inverse Relationship.
GBP/USD = 1.8750 USD/GBP = 1.00 / 1.8750 = .5333

Currency Pairs
EUR/USD
Buying the Pair

1st Currency Bought & 2nd Currency Sold

+1 EUR/USD
Buying EUR & Selling USD

Selling the Pair

1st Currency Sold & 2nd Currency Bought

-1 EUR/USD
Selling EUR & Buying USD

Currency Pairs
USD/CAD
Base Currency?
USD

Counter Currency?
CAD

If you BUY the pair, what currency in the pair must appreciate for you to profit? USD

Currency Pairs
AUD/USD
Base Currency?
AUD

Counter Currency?
USD

If you Sell the pair, what currency in the pair must appreciate for you to profit? USD

Currency Pips
Contract Sizes
100,000 Units of Base Currency
A LOT 4 lot controls 400,000 base currency

10,000 Units of Base Currency

Mini Contract or Mini Lot 7 mini-lots control 70,000 base currency

Currency Pips
A PIP is the smallest unit of measure for movement in the FX Market
Acronym for Percentage in Point USD/CHF = 1.0980 CHF/USD = 1.0980

Currency Pips
Value of a PIP
100,000 Units of Base Currency
1 PIP =$US10.00

Value of a PIP
10,000 Units of Base Currency
1 PIP =$US1.00

Currency Pips
Value of a PIP
100,000 Units of Base Currency
Example
Long 5 USD/CAN = .8950 USD/CAN = .9050 Profit/Loss ? Profit $CAN 5000.00 5 x $CAN 1000 ( 100 pips @ $CAN 10.000 per)

Currency Pips
Opening Trade USD/CAN
$US 100,000 exchanged for $CAN 89,500
USD/CAN .8950 5 x $CAN 89,500 = $CAN 447,500

Closing Trade
$CAN 99,500 exchanged for $US 100,000
USD/CAN = .9950 5 x $CAN 99,500= $CAN 497,500

Profit $CAN 497,500 - $CAN 447,500 = $CAN 5000.00

Currency Pips
Value of a PIP
100,000 Units of Base Currency
Example
Long 3 EUR/USD = 1.5750 EUR/USD = 1.5775 Profit/Loss ? 3 x $US 250.00 ( 25 pips @ $US 10.000 per) Profit $US 750.00

Currency Pips
Value of a PIP
10,000 Units of Base Currency
Example
Short 5 AUD/USD = .9550 AUD/USD = .9580 Profit/Loss ? 5 x $US 30.00 (30 pips @ $US 1.000 per) Loss $US 150.00

Currency Pips
Value of a PIP
100,000 Units of Base Currency
Example
GBP/USD increases from 1.8750 to 1.8760 1 PIP =$US10.00 Long 1 GBP/USD profit = $100.00 Short 5 GBP/USD loss = $500.00

Currency Pips
Value of a PIP
10,000 Units of Base Currency
Example
AUD/USD increases from .8590 to .8600 1 PIP =$US1.00 Long 1 AUD/USD profit = $10.00 Short 5 AUD/USD loss = $50.00

Currency Pips
Value of a PIP
100,000 Units of Base Currency
Example
Long 6 EUR/USD = 1.4750 EUR/USD = 1.4775 Profit/Loss ? Profit $US 1500.00 6 x $US 250.00 ( 25 pips @ $US 10.000 per)

Currency Pips
Value of a PIP
100,000 Units of Base Currency
Example
Long 3 EUR/USD = 1.4750 EUR/USD = 1.4730 Profit/Loss ? Loss $US 600.00 3 x $US 200.00 ( 20 pips @ $US 10.000 per)

Currency Pips
Value of a PIP
10,000 Units of Base Currency
Example
Short 6 AUD/USD = .8650 AUD/USD = .8605 Profit/Loss ? Profit $US 270.00 6 x $US 45.00 (45 pips @ $US 1.000 per)

Currency Pips
Value of a PIP
10,000 Units of Base Currency
Example
Short 4 AUD/USD = .8550 AUD/USD = .8580 Profit/Loss ? Loss $US 120.00 4 x $US 30.00 (30 pips @ $US 1.000 per)

Currency Pairs
Arbitrage insures this mathematic relationship is present is all transactions
GBP/USD = 1.8750 USD/GBP =.6000
Sell GBP/USD 1.8750 Buy USD/GBP .6000
1.00/.6000 = 1.6667

1.8750 1.6667 = .2083 USD Profit

You will NEVER Find this Trade!

Bid / Offer Spreads

One-Sided Market
Buying gasoline is a 1 sided market You pay $US 4.00 for 1 gallon

Two-Sided Market
Purchase of a Real Estate
Buyer Submits a Bid Seller Offers the Property

Bid / Offer Spreads

Financial Two-Sided Markets
Buyers always bid Seller always offer
Refers to Long/Shorts contracts, not to the direction needed for profit

Bid / Offer Spreads

Trader Talk Bid
Price for Quantity
.75 Bid for 10 GBP/USD Spot

Offer
Quantity at Price 10 GBP/USD Spot at .75

Bid / Offer Spreads

Bid / Offer Spreads

Bid / Offer Spreads

Bid / Offer Spreads

What is the Current Bid? 1.5677 What is the Current Offer? 1.5679 What price will YOU buy $10,000 EUR/USD? 1.5679 What price will YOU sell $10,000 EUR/USD? 1.5677 How wide is the market? 2 pips

Bid / Offer Spreads

What is the Current Bid? 1.9745 What is the Current Offer? 1.9749 What price will YOU buy $10,000 GBP/USD? 1.9749 What price will YOU sell $10,000 EUR/USD? 1.9745 How wide is the market? 4 pips

Bid / Offer Spreads

Main source of Revenue for the Market Maker / Broker No addition fees for executing these spot trades

FX Spot Margin
Allows a trader to leverage the cash in their trading account
Dont need full cash value of the trade

Margin up to 100:1 for 100,000 Unit and 10,000 Unit Trades Leverage must be managed!

Order Designations
Opening
Initiates or adds to an existing position

Closing
Reduces or closes an existing position

Order Types
Market Limit Stop / Stop Loss One Cancels Other / OCO Day Order Good till Cancelled / GTC

Order Types
Market Order
Executed immediately within the current market conditions. Fastest way to execute Price not a concern

Order Types
Market Buy
Order to Buy @ the lowest offer. Continues to chase the offer until filled

Order Types
Market Sell
Order to Sell on the highest bid. Continues to chase the bid until filled

Order Types
Limit Order
Bid or Offer at a price you determine May not execute immediately if it is away form the market Can allow you to trade between the markets

Order Types
Limit Order Buy
Bid at a price you determine May not execute immediately if it is away form the market Can allow you to trade between the markets

Order Types
Limit Order Sell
Sell at a price you determine May not execute immediately if it is away form the market Can allow you to trade between the markets

Order Types
Stop / Stop Loss
A limit order placed above/below the current market Becomes a Market Order once the underlying trades at the limit price. Used to minimize risk

Order Types
One Cancels Other / OCO
Order combines a stop order and a limit order Only 1 trade will be executed. The other will cancel. Perfect way to manage an active spot trade

Order Types
Day Order
The order stays active in the system until it is executed or the close of New York Trading Day for traders in the US.

Order Types
Good till Cancelled / GTC
The order remains active until it is executed or cancelled.

Order Types
Good till Close of Market TOS
The order stays active in the system until it is executed or the close of Trading Day you choose.

What is an Option?
Options are contractual agreements to buy or sell stock at a specific price over a given time period. Derivative instruments Danger depends on how they are used! Options created to hedge risk.

Long Options
Call options: Give the owner the right, not the obligation, to buy an underlying security a fixed price over a given period of time. Call away from owner. Put options: Give the owner the right, not the obligation to sell an underlying security at a fixed price over a given period of time. Put it back to owner.

Short Options
Call options: Give the seller the obligation to sell an underlying security at a fixed price over a given period of time. Put options: Give the seller the obligation to buy an underlying security at a fixed price over a given period of time.

Rights vs. Obligations

If you buy an option, you are long the position. You have the right to buy (call) or sell (put). The seller of the contract, or short position, has an obligation.

Call Long Short

Right to buy Obligation to sell

Put
Right to sell Obligation to buy

Call Option

Expires 10/31/08

Expires 10/31/08

Long calls have a right to buy

short calls have an obligation to sell

Put Option = Car Insurance

Puts are like car insurance

The price you pay is called the premium. The policy expires at some time If your currency pair gets wrecked, you can always put it back to the insurance company for the face value of the policy. If you dont use your insurance, you lose the premium You can absorb some of the risk (by accepting a deductible) and pay a smaller premium

Long puts have the right to sell

short puts have the obligation to buy

Options are similar to Underlying Securities:

Options are securities. They trade in contracts rather than shares. Options trade on national SEC (Securities Exchange Commission) regulated exchanges. Option orders are transacted through market makers and retail participants with bids to buy and offers to sell and can be traded like any other security.

Options are different from Underlying Securities:

Options have an expiration date. Options only exist as "book entry." There are no certificates. There is no limit to the number of options that can be traded on an underlying stock. Common stocks have a fixed number of shares outstanding. Options do not confer voting rights or dividends.

Terminology: Premium
The price you pay for an option is called the premium. Remember that each contract controls 10,000 underlying base currency so the premium must be multiplied by 10,000 to get the total contract value.

Terminology: Exercise Price or Strike Price

If you exercise your option, you will pay the strike price (for call options) or receive the strike price (for put options). Exercise price = Strike price.

Terminology: Moneyness
Options are classified as: In-the-money Out-of-the-money At-the-money Exchanges always try to maintain at least one of each.

Terminology: Time Decay

Because options expire, a portion of their price will erode with each passing day. This is called time decay. Is time decay necessarily bad? Can you think of an asset youve purchased that is exposed to short time decay?

Time Values vs. Intrinsic Values

An options price can be broken down into time value and intrinsic value.

$8 $5 $3

Volatility
Volatility is the major determining factor of an options price.

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Thank You.
Gregory McDermott, MApp Fin OU Chief FX Strategist
gmcdermott@optionsuniversity.com