Basic Options Terms

The strike price is the price at which the call or put may be exercised. It does not make sense to exercise a call or put (exchange it for a spot position) unless the call or put is in the money -- trading above (call) or below (put) the strike price.

You may, of course, offset your option, buying it back (a put) or selling it (a call) before the expiration even if it is not in the money. You have effectively transferred your contractual obligation to someone else.
You might purchase a call out of the money and sell it out of the money and still profit thereby.

The expiration is the time frame of the option. In stocks and commodities, these are normally set for months. An option is said to expire in September, for example. In FOREX, the expiration dates are closer since very few traders hold positions for months at a time.

The premium is the cost of the option. With options, you are paying for the time-value as well as the price values. The underlying value of the option falls as time approaches the expiration -- unless the price value increases at a faster rate. Options pricing, because of these twin values, can be complex and unpredictable. You can be correct on the price direction and still lose money because of decaying time values.

The intrinsic value of an option is what it is worth if exercised at any given time. When an option is out of the money, its only intrinsic worth is time value.

A call is in the money if the spot price is above the strike price and out of the money if below. A put is in the money if the spot price is below the strike price and out of the money if above.

The price of an option, or premium, is determined primarily by strike and expiration vis-à-vis the current price of the underlying currency. But there are other factors, such as liquidity, speculative fervor, and volatility. For example, an out of the money call is more valuable if the underlying currency is volatile; it has a better chance of going to in the money. Forecasting option prices -- even knowing or inputting the price of the underlying currency -- is far from an exact science. A small change in time value or price value may cause the option price to change by an inordinate amount. The various price factors appear to interact in a nonlinear fashion. Math whizzes will find a similarity to the famous n-body problem.

A vanilla option is one with only the basic components of expiration date and strike price. An exotic option contains complicated features and complex payoffs that often are determined by outside factors. Exotic options are mathematically complex; going to the moon was easier than predicting exotic options in the author's humble opinion.

Traditionally, currency options have been of two types:
  1. American style: This type of option may be exercised at any point up until expiration.
  2. European style: This type of option may be exercised only at the time of expiration.

If you trade with options, consider only American style, vanilla.
By Michael Duane Archer
Michael Duane Archer has been an active futures and FOREX trader for more than 35 years. He has worked in various advisory capacities, notably as a commodity trading advisor, registered SEC investment advisor, and branch manager for Heinold of Hawaii. He currently trades FOREX and futures and is involved in several technical analysis research projects.

Copyrighted 2016. Content published with author's permission.

Posted in ...