A trader who knows the Forex market “from the inside” can trade using option levels, ie. familiar with its structure and work algorithm. It is also important to understand the principles of work and interaction of all its participants. Unlike Forex, the stock options market is considered to be quite organized. Therefore, we can always use his data on options for the futures we need. Today I will tell you what an “option” is, where to get the necessary information to plot option levels and how to use the option levels indicator.
What do we call an “option”?
Option literally translated from Latin ( “optio” ) means “opportunity”, “choice”. On the exchange, this word should be understood as a contract or agreement between two parties, where:
- One party – the option buyer, gets the right (not the obligation!) To buy / sell the selected underlying asset at a certain time interval and at a specific price;
- The second party – the seller of the option, according to the terms of the contract, undertakes to provide such an opportunity to the first party.
Note that the right-obligation relationship puts the buyer and seller of options on an unequal playing field. This is of great importance to us, but what is the point, I will tell you a little later.
The definition of an option is very similar to the definition of a futures, although there is a difference between the two. Futures is a contract for the purchase / sale of currency in the future, according to which:
- the buyer is obliged to buy a certain amount of currency at the exchange rate established at the time of the transaction;
- the seller undertakes to sell him the currency within the agreed period.
The difference is that the option imposes certain obligations only on the seller, while the futures obliges both parties to fulfill the terms of the contract. The buyer of the option can buy the asset at the agreed time or refuse to buy, losing only the value of the option itself – the official paper, the value of which is 2% of the total transaction amount . At the time of the conclusion of the option, all its main parameters are stipulated:
- Premium – the option value (a value that changes depending on the market situation);
- Expiration – the term of the agreement, after which the buyer loses the right to use it;
- Strike ( “strike price” – English) – the price for the sale / purchase of an asset agreed in advance for the buyer;
- Holder / Taker / Holder – the one who buys the options;
- Contract – the volume of an asset in lots specified in the contract (for example, 1 lot on the stock market = 100 shares);
- Reiter / Grantor – one who sells options;
- Redemption of an option – the use of the right under an agreement to sell / purchase an asset;
- Put option – the right (under the contract) to sell the underlying asset;
- Call option – the right (under the contract) to buy the underlying asset.
When buying an option, the buyer gets the right to sell / buy the underlying asset in the future – certain goods, financial instruments. Precious metals, Forex currency, stocks, fuel, grain, fruit / flower crops, etc. can be used as goods.
Briefly about the history of options
Options and futures have been around since 1630, when the tulip fever swept the world. There were many who wanted to get rich growing tulips, but not everyone had the right amount of start-up capital to buy the bulbs of this flower. This is how “fixed-term contracts” appeared, opening the way to business for people who do not have the means to buy at least one bulb.
Options for shares of enterprises first appeared at the beginning of the 19th century on the London Stock Exchange. At the end of the 20th century, options appeared in the United States. The variety of the options market that we face today did not begin until the beginning of the 21st century. Let’s, so as not to go deep into history, just take a look at the basic chronology of the development of stock options trading.
What are options?
All financial instruments that exist today can be roughly divided into several categories. This greatly simplifies the assessment of the risks and the level of profitability of various underlying assets listed on the exchange. So, based on the categories, options are distinguished by:
1. By type (among themselves these options differ in maturity):
- American options are redeemed on any day of the calendar period pre-agreed in the agreement, determining, in fact, only the deadline for their placement on the exchange;
- European options can be redeemed only on the date set by the contract (as they say, according to the “classics” of the genre);
On exchanges, as a rule, preference is given to American options.
2. By time:
- Short term (1 – 16 weeks).
- Long-term (for 4 months or more);
3. For the underlying asset:
- Foreign exchange (Forex trading in cash and foreign exchange futures);
- Stock (shares of large companies – issuers, index futures);
- Commodity (physical goods – raw materials, metals, oil and commodity futures);
- Interest (bonds, loans, future interest rate agreements, interest rate futures);
- Index (stock indices).
An option that gives one party the right to sell / buy the underlying asset at a specified price within a certain period of time can act as:
- With a security;
- Contract between investors;
- A standard document with agreed terms on both sides;
- A financial contract for the implementation of the rights of its Holder.
Forex options are a type of currency options (FX options). The buyer of the FX option gets the right to exchange one currency for another on a specific calendar date and at a previously agreed rate. Most often, they are used by exporters / importers in order to hedge risks in the event of a change in the exchange rate of foreign economic contracts and currencies for the purchase / sale of goods in domestic markets. An FX option is an agreement for the right to exchange currency on a specific calendar date.
There is one feature in this trading instrument that is difficult for a beginner trader to understand. In Forex, we sell (“short”) when the price moves down and buy (open long positions) when it reverses and moves up. In options trading, everything happens a little differently:
- To buy the underlying asset, you should buy a Call-option ;
- For sale – buy Put-option .
If you noticed, then we should buy in both cases.
4. By types of transactions:
One asset allows you to conclude four types of transactions on it. We have considered two main transactions above:
- Buying a Call option implies an increase in the underlying asset;
- Buying a Put option means decreasing it.
It is not difficult to understand if the first one sells something, that is, the other one who will buy it and vice versa. This gives four options trades:
- Call option buyer (expects the growth of the selected asset in the future);
- The seller of the Call option (expects that the underlying asset will not grow and the counterparty who bought the option from him does not exercise his right to buy, leaving him a collateral).
- Buyer of the Put option (believes that the price of the selected asset will decrease in the future);
- The seller of the Put option (as in the situation with the Call option , the seller can only count on the profit on the collateral received in the event of non-execution of the contract through the fault of the buyer).
One more note: in the vast majority of cases, the sellers of FX options are market makers who have, in fact, unlimited risks. It is difficult to outplay them even for an experienced trader, but for a beginner it is a very big risk.