There are two basic types of options.  A call option is the right but not the obligation to purchase an asset such as gold at a specific price referred to as the strike price, on or before a certain date known as the expiration date.  A put option is the right but not the obligation to sell an asset.  The buyer of an option pays the seller of an option a premium for the right to buy or sell the underlying asset.  Generally options with longer times to maturity have greater premiums than options with shorter times to maturity. 

The value of a gold option has two components.  The first is intrinsic value.  This is the difference between the current price of gold and the strike price of the option.  For example, if the current price of gold is $1,600 and the strike price of an option is $1,500 then the intrinsic value is $100 ($1,600 – $1,500 = $100). 

The second component is called the extrinsic value or time value.  This is the value of a gold option beyond the intrinsic value.  For example, if the price of a 30 day gold option with a strike price of $1,500 when the price of gold is $1,600 is $130, then the intrinsic portion as shown earlier is $100 and the time value is $30 ($130 – $100 = $30).  If the strike price on a call option is above the current price of gold, then the entire value of the option is time value. 

The price of an option is created by market participants, who estimate the value of gold options based on options pricing models.  The basic gold options pricing model is the Black Scholes pricing model.  This type of pricing model attempts to determine how much a buyer should pay based on the probability that the gold market could move from the current level to the strike price prior to expiration of the option. 

To estimate the probability, options traders use implied volatility which is the markets estimate or how far gold prices will move in percentage terms on an annualized basis.  In addition to implied volatility, options traders will use the current price, the strike price, the time to maturity and current interest rates as inputs into their pricing model.

Gold options traders will use a number of strategies to trade gold prices.  The will speculate on the direction of the gold market using basic calls and puts, as well as trade strategies that will speculate on the direction of implied volatility, which are called straddles.  A straddle is the purchase of a call and put option at the same strike price.  The buyer of a straddle does not care about the direction gold moves in, but is more concerned about that gold moves quickly and the volatility of the gold market increases. 

There are dozens of strategies that can be used to trade gold using options, and options on gold assets are liquid and transparent.  If you are interested in trading gold using options then Options House is one of the better brokers out there while if outright gold investment then Bullion Vault is our company of choice.

The post Using Options to Trade the Gold Market appeared first on Options Trading.

The counterpart to this agreement is the seller, who in the case of call options has the obligation to sell an underlying asset at the strike price and in the case of put options to buy it at the strike price.

If the buyer of the option exercises their right in terms of the option, the seller is said to get exercised or assigned. Naked call or put options get exercised automatically if they expire In The Money – otherwise they simply expire worthless.

Exercise Explained

The whole concept of ‘getting exercised’ or ‘getting assigned’ is often blown out of proportion. If one carefully analyses what actually happens it is not as terrible as it sounds.

If a trader should sell naked call options on stocks, for example, and they expire In The Money, the trader has to deliver the shares at the strike price, regardless of the current market price. If the strike price of the options was $120 and by expiration the stocks are trading for $130, the trader actually has to buy stocks at $130 (if he or she doesn’t already own them) and sell them for $120 each to the owner of the long call options – at a loss of $10 per option, i.e. $1000 per contract.

A trader selling naked put options on stocks is in the reverse position: he or she has to buy the shares at the strike price regardless of the market price at expiration. If the strike price of the options was $80 and the share price drops to $70 by expiration, this trader has to buy the shares from the owner of the put options for $80 per share while the market price is only $70. Once again this represents a loss of $10 per share.

Getting exercised compared to owning stocks

If we compare the position of someone who owns stocks with that of a trader who sells naked puts, for example, we will see that their profit/loss scenarios are not that different.

Consider the case of Investor Jack who owns 100 shares of Company ABC. The shares are currently worth $100 each, a total investment of $10 000 therefore. Trader Jill owns no shares. She, however, sells 1 naked put options contract representing 100 shares in company ABC with a strike price of $100.

Should the price of Company ABC shares drop to $85 by expiration, Investor Jack will lose $15 per share with a total loss of $15 x 100 = $1 500.

Trader Jill will be exercised and she will have to buy 100 shares of Company ABC at $100 each despite the fact that they are only worth $85 each at current prices. She also makes a loss of $15 x 100 = $1 500.

The difference between the two is that Trader Jill received a premium when she sold the put options. Assume this was $4 per option. Her total loss is therefore $1500 – $4 x 100 = $1 500 – $400 = $1100.

If the share price of Company ABC remained stagnant at $100, Trader Jill would still get to keep the premium she received for selling the put options ($400), while the stock owner would show no profit at all.

Conclusion:

While there is no doubt that getting exercised/assigned can be very costly to an options seller, the maximum loss is no bigger than that of someone who was long or short an actual stock position. In many cases the options seller will actually be in a better position.

The post What it means to get exercised in options trading appeared first on Options Trading.

A stop loss often simply does not help much, especially if it is virtually certain the price will eventually turn around and head in the ‘right’ direction. What one needs is a hedge to remain in the trade no matter in which direction it goes.

A hedge is simply a ‘counter-transaction’ that will protect a trade against potential losses by way of making a profit if the price of the underlying asset moves against the trader (or investor).

With the advent of options, a whole new world has opened up to traders, enabling them to more effectively hedge stock, FX or futures positions than at any time in the past.

A simple example: The protective put

The protective put is a very basic example of a hedge. A trader who is in a long position on a stock would simply buy one ATM put contract for every 100 shares he or she owns in the underlying stock.

Fig. 9.03 (a) below is an example of the risk profile of the new trade.

Fig. 9.03(a)

From the above chart it is immediately clear that: 

1. If the price of the shares goes up, the trader will still benefit from the full price increase, less the cost of the put options.

2. If the price goes down, the trader does not stand to lose a virtually unlimited amount of money; instead his or her losses will be limited to the cost of the long put options.

Hedging against price increases

A manufacturer who stands to lose from a price increase in e.g. the price of oil, could benefit from hedging against this eventuality by buying call options on oil. Fig. 9.03(b) shows this person’s new risk profile after buying call options to hedge against price increases.

Fig. 9.03(b)

From this chart it becomes clear that:

1. If the price of oil increases, the maximum loss remains equal to the purchase price of the call options and

2. If the price of oil declines, the manufacturer would still benefit from the full drop in the price of the commodity, less the cost of the call options. 

When to hedge and when not to

Some long-term traders (investors) refrain from hedging their portfolios because they have the mistaken belief that the stock market will always go up in the long term. The turmoil through which markets went after the 2007 financial crisis in the US which subsequently swept through virtually the whole world proved this to be not true.

The only time a hedge is not worthwhile is when the potential price decline of the underlying asset is less than the cost of the hedge. Buying ATM put options costs money and it makes no sense to spend $20 000 on a hedge of the expected downside risk is only $10 000. Since accurately assessing downside risks is very difficult indeed, hedging a portfolio makes sense in virtually every possible scenario one can think of.

Conclusion

Hedging is what allows professional traders to remain in business for years, while many retail traders are forced out of the market once they have lost a significant percentage of their trading accounts. It is also a common practice in the world of international trade where millions can be lost or gained by protecting oneself against fluctuations in the prices of currencies and/or commodities.

The post Using options to hedge a trading position appeared first on Options Trading.

Understandably the broker had to charge a fee for the time it took to communicate with the customer and then execute the trade. It also has to be said that the services of the broker usually went beyond merely taking and executing orders. There was usually a fair amount of consultation involved.

Broker assisted trading is still available and for beginner traders and investors it might be the perfect way to get started. Paying for the advice of someone who knows the market through years of experience could be well worth the price.

For traders choosing the online route of self-trading however, it is important to watch the costs. These usually consist of two elements: direct commissions and the spread.

Commissions

With stock options trading the general rule is that the trader would charge a fixed fee per transaction and an additional fee per contract. Since this article is not about recommending specific brokers an explanation of how different commission structures could affect the profitability of a trade might be helpful.

Smaller traders in particular should try to find a broker with a lower fixed transaction fee. For a trade consisting of only 2 contracts, paying $20 per transaction boils down to $10 per contract – which could well turn a marginal trade into a losing one.

Traders who trade in larger volumes would be wise to compare ‘per contract’ fees of different brokers. In this case it’s of no use paying a small fixed transaction fee and a high per contract fee.

Example:

Broker A charges a fixed transaction fee of $10 per trade plus $2 per contract. Broker B charges a fixed transaction fee of $20 plus $1 per contract. Which one is the cheapest?

Fig. 9.05(a) below confirms our initial conclusion:

Fig. 9.05(a)

In this hypothetical example broker A would be the cheapest for smaller traders. The break-even point is at 10 contracts. For trade sizes above 10 contracts broker B becomes the cheapest.

Spreads

Traders who trade in FX options might well think they are not paying any commissions. 

That would be a huge mistake. Although there are usually no direct commissions, or relatively small commissions, in trading this type of options the wide spreads could result in even higher commissions than those charged for stock options.

An expansion of the example in Fig. 9.05(b) will explain the issues involved. In this case broker C has been added, who charges no fixed transaction fee and no per contract fee, but the difference between the Bid and the Ask price for this broker is 0.03. For the purposes of this example it is assumed that broker A and broker B have spreads equal to zero, which is useful for comparison purposes.

Fig. 9.05(b)

From the summary above one can immediately see that, despite the fact that he charges no direct fees, broker C becomes more expensive than either broker A or broker B for trades consisting of more than 10 contracts.

While in the real world virtually all brokers will have spreads exceeding 0, a simple spreadsheet will be useful to quickly determine which broker in fact offers the best value for money.

The post Spreads and commissions and how they affect your profits appeared first on Options Trading.

The type of options trade and when you should enter it, for example, differ sharply between
range-bound and trending markets.

Range-bound markets

A range-bound market is one where the price of the underlying asset moves up and down
over time with a clearly defined upper and lower limit. At the time of writing the gold price is
range-bound, but over time most trading assets will spend quite a significant percentage of
their time trading in certain ranges.

Fig. 8.22(a) below is what the price chart for a typical range-bound market would look like.

Fig. 8.22(a)

In a scenario like this point A, where the market has reached its top and has started turning
around, would be ideal for one of the following options strategies:

a) Sell naked call options with a strike price above the top turning point of the range and
an expiration date timed to coincide with the price reaching the bottom of the trading
range. These will then expire worthless and the trader will keep the full premium of
the options.
b) Buy ATM put options with the same expiration date as in (a) above. As long as the
price movement between the top and the bottom of the range is sufficient to cover the
cost of the options and more, the trader will make a profit at expiration.

At point B, the market has reached the bottom of the range and is starting to turn upwards.
This is when the trader should enter into one of the following positions:

a) Buy ATM call options. Once again the expected price movement should be sufficient
to cover the cost of the option in order to break even and start generating a profit.
b) Sell naked put options with a strike price below the bottom of the range and an
expiration date timed to coincide with the market reaching the top of the range. These
will expire worthless, providing the trader with a profit equal to the premium on the put
options.

Trending markets:

Fig. 8.22(b) shows a typical trending market.

Fig. 8.22(b)

At point A in this chart the price has gone through a correction and started moving
upwards again. At this point the options trader’s strategy would be directly opposite to the
explanation at point A under range bound markets above. This is crucial to understand; the
wrong decision here would result in one losing trade after the other.

Point A in a trending market is where strategies such as the following are recommended:

a) Buy call options, either ATM or OTM if it is fairly certain the option would exceed the
     OTM strike price by the expiration date
b) Sell naked put options. The strike price should be below the previous support level to
     make sure the market doesn’t surprise the trader with a sudden ‘whip-saw’.

The post Using charts to time an options trade appeared first on Options Trading.

As we will see below, both perceptions are equally flawed. There are indeed risks involved in
options trading, but if these risks are properly managed options trading can be a lower-risk
vehicle than share investments or futures trading.

The correct way to approach the issue is by looking at both the risks and the rewards and to
calculate the probabilities that each will become a reality.

Risks when buying options

When a trader purchases an option, the only way in which that trader can profit is if that
option expires above the strike price. Below that level such a trader stands to lose his full
investment. Fortunately this is limited to the purchase price of the option.

Many options buyers make the mistake of looking only at the profit/loss ratio of an option,
without taking into account the probability of achieving that particular outcome.

Risks when selling options

The risk profile faced by an options seller is the reverse of that of an options buyer. If the
options expire below the strike price, the options seller keeps the full amount of the premium
received from writing (selling) the option.

Above the strike price of naked call options, the options seller faces unlimited risk to the
upside – the risk is only limited by how much the underlying asset can increase in price up to
the expiration date of the option.

Contrary to popular belief, the seller of naked put options does not face unlimited risk to the
downside. His or her risk is limited by the price of the underlying asset – which cannot drop to
a level below zero. From that loss should still be deducted the income derived from selling the
put in the first place.

Risk versus reward – the full picture

Let us assume trader John has to decide whether to buy or sell a 1-month call option on
company ABC shares. He has the following information at his disposal:

- The current price of ABC shares = $100
- The strike price of the option = $103
- The option is priced at $1.00
- Current volatility of ABC shares = 17%

Using an options probability calculator, trader John calculates that the option has a 24%
probability of ending In the Money. If he should buy the option, he therefore faces a 24%
probability of either breaking even or making a profit. He also faces a 76% probability of
losing the money he spent on buying the options.

Selling the option would provide him with a premium of $1 per option (commissions
excluded). There is a 76% probability that he will be able to keep this premium and a 24%
probability that the option would expire in the money and he would therefore make a loss on
the trade.

Options buyers therefore typically face numerous small losses followed by a couple of
large profitable trades, while options sellers face many small profitable trades and a few big
negative ones which, if not managed properly can wipe out their trading accounts.

The post Risk versus reward in options trader appeared first on Options Trading.

What is important to remember is that the terms ‘American’ and ‘European’ have nothing at
all to do with where the options are traded. In fact both types of options are trades in both
America and Europe.

Implications

One of the most important implications with a European style option is that it will normally be
cheaper than its American-style counterpart. This is because it is less flexible.

While a European-style option can only be exercised on the expiration date, it can still be
bought and sold before the time, just like American-style options. In this regard it is therefore
similar to a warrant or even a futures contract.

Where European-style options really differ from American-style options is in the fact that they
cannot be assigned before expiration. The dreaded fear of early assignment (which is often
highly overrated) with which all writers of American style options have to live does therefore
not exist with European-style options.

Another difference between the two exercise styles is that European-style options normally
stop trading the day before expiration. This means a trader will not be able to get out of a
losing trade on the last day, neither will he or she be able to exit in a profitable position before
it retracts below the strike price.

Pricing of American-style versus European-style options

As mentioned above, European-style options are normally cheaper than American-style
options. This explains why the popular theoretical options model called Black-Scholes
very often calculates an option price that is lower than the actual price: it was developed for
European-style options, so it doesn’t work so well with American-style options.

On expiration day the settlement price of European-style options are also calculated in
a different way than that of American-style options. With the latter the closing price of the
underlying asset is used to determine whether an option ended ITM, ATM or OTM.

European-style options go through a mark-to-market process where the final settlement
price is only determined a few hours after expiration. This understandably creates a lot of
stress for traders who are in possession of options for which the final price closed just a few
cents on either side of their strike price. They literally have to await the verdict of the judges
before they know whether they made a profit or a loss.

How to know

How does one know whether the options one is buying or selling are European-style or
American-style? An easy hint is that virtually all cash-settled options are European-style.
Index options are usually European-style too, while nearly all stock options traded in the
United States are American-style options.

The post American style options versus European style options appeared first on Options Trading.

Options backspreads are trading strategies, which have the aim of benefiting from volatile
markets. In this context a volatile market is where a sharp price increase or decrease
is expected. Typical examples of such a situation is just before publication of financial
statements, major news releases or court cases.

Backspreads are able to profit whether the market price of the underlying asset goes up
or goes down, as long as this movement is significant. If the price remains stagnant or in a
narrow range, the options backspread trader will typically lose a limited amount of money.

A backspread could, however, still make money in a stagnant market if the volatility of the
underlying asset price increases sharply. This is why those who favour backspreads usually
enter the trade relatively long before any major announcement from that particular company is
expected; their aim is to ‘ride the volatility wave’ all the way to its end.

Examples of backspreads

Below we will discuss a few examples of backspreads.

The long straddle

The simplest yet still one of the most popular backspreads is no doubt the long straddle. Fig.
8.31 (d) below is an example of a long straddle, consisting of a long ATM put and a long ATM
call.

Fig. 8.31(d)

From the above chart it is clear that the trade will:

a) Be profitable if the underlying asset price moves sharply up or down and
b) Make a limited loss if the price remains stagnant or within a narrow range

The long straddle is a debit spread, i.e. it will cost the trader money to enter this trade. Below
we will discuss another options backspread, the call ratio backspread, which is a credit
spread.

The call ratio backspread

The call ratio backspread is similar to the long straddle in the respect that it will be profitable
whether the price of the underlying moves sharply up or down. It has unlimited profit potential
to the upside and limited profit potential to the downside. If the price trades within a narrow
range up to the expiration date, the trader will make a limited loss.

Fig. 8.31(e) below is a graphical illustration of the call ratio backspread.

This trade is entered into by buying more ATM or OTM call options than the number of ITM
call options that are purchased.

Example:

The share price of Company ABC is trading at $91. A call ratio backspread can be entered
into by selling 1 contract of $87 call options (ITM) and simultaneously buying 2 contracts of
$91 call options for the same expiration date.

Since the ITM call options are more expensive than the ATM calls, the trader should be able
to enter this trade for a net credit, i.e. without parting with any money upfront.

If the price of the underlying asset moves sharply downwards the trade will profit with the
amount of the net credit; if it moves sharply upwards the trade has an unlimited profit potential
and if the price remains stagnant the trade will make a limited loss.

Conclusion

Backspreads are best for when sharp price changes are expected. If Murphy’s Law results in
a stagnant price, the trader could lose a substantial amount of money. Fortunately this can
be calculated before the time to determine whether the reward/risk ratio makes for a sensible
trade.

The post Options Backspreads Explained appeared first on Options Trading.

At any given moment during its lifetime, an option is either In the Money (ITM), At the Money
(ATM) or Out of the Money (OTM). An In the Money option is therefore only one of the 3
options ‘moneyness’ states.

A trader who understands how options are priced will find it easier to understand the concept
of an option being In the Money. An ITM option is one that has both intrinsic value and
extrinsic value. The biggest part of an option’s extrinsic value consists of time value,
although there are other components such as volatility and interest rates.

All options have extrinsic value when they are sold. ITM options, however, differ from
ATM and OTM options in the respect that it also has intrinsic value. What follows is a brief
explanation of this concept.

ITM call options and intrinsic value

A call option, which gives the owner the right to purchase the underlying asset at a price
below the current market price, is said to have intrinsic value.

If the shares of Company ABC are therefore trading at $30 at present and a trader buys an
ITM call option with a strike price of $20, that option gives the trader the right to buy ABC
shares at $20 instead of the going rate of $30.

This difference of $10 is called the intrinsic value of the call option. The initial price of the
option will, however, be higher than $10. The first $10 of its price will be the intrinsic value.
Apart from that there will also be an extrinsic element, depending on the time to expiration,
the volatility and interest rates. The actual value of the option might therefore be something
like $13.

If at expiration date the price of ABC shares is still $30, the option will not be worthless as
would be the case with an ATM or OTM option. It will only lose the extrinsic value, which in
this case was $3 ($13 – $10). The option would at expiration therefore still be trading at $10.
This is why ITM options are often considered to be safer for beginner traders than ATM or
OTM options.

ITM put options

Put options are considered to be In the Money (ITM) when their strike price is above the
current market price of the underlying asset.

Going back to the example above, if company ABC shares are trading at $30 at present, a put
option with a strike price of $40 would be $10 in the money, because it allows the owner to
sell shares of Company ABC for $40 while the going market price is $30.

If the share price of Company ABC remains stagnant at $30 between now and the expiration
date, the $40 strike ITM option would still be trading at its intrinsic value of $10 by expiration.

Delta of ITM Options

In the Money options have a higher Delta than either ATM or OTM options. This means they
follow movements in the price of the underlying much more closely than the latter. If the
option is kept to expiration, this plays no role, however.

Summary:

Fig. 8.29(a) provides an overview of how ITM options relate to OTM and ATM option. Notice
that ITM calls are below the current market price and ITM puts are above the current market
price.

The post In the Money Options Explained appeared first on Options Trading.

Since the majority of this FX options trading takes place over the counter (OTC) it is not
heavily regulated. A small percentage of trades take place through exchanges such as
the Chicago Mercantile Exchange, the Philadelphia Stock Exchange and the International
Securities Exchange.

Online FX and Futures Options brokers abound nowadays. Be sure to compare the
commissions, spreads and reputation of a few of these brokers before depositing any money.

Currency options

Currency options (FX options) are similar to options on stocks in many ways, but there are
also important differences. A currency option gives its owner the permission, but not the
obligation, to buy or sell a given currency pair at a given price on a certain future date.

The important difference here is that we are dealing with a currency pair, which some traders
find confusing. What follows is a brief explanation.

If a trader expects the USD/GBP exchange rate to come down between now and a certain
date in the near future, he or she can buy a put option on this currency pair. Alternatively one
could sell call options on the USD/GBP pair.

Conversely, if one expects the USD/GBP exchange rate to increase in the near future, one
could either buy call options or sell put options on this currency pair.

Whether a trader decides to buy put/call options or sell call/put options depends on whether
he or she expects the rate to move strongly up or down or only slightly. If a strong move is
expected, buying put or call options is the better choice. For a smaller move selling call/put
options will be a better solution.

Options on futures

Similar to currency options, it is also possible to trade in futures options. Once again a call
option here gives one permission, but not the obligation to buy the futures contract at a
certain price and a put option the right but not the obligation to sell it at the strike price on the
expiration date.

Futures options are available on a vast variety of tradable assets, including stock indexes like
the S&P 500 and commodities such as gold, oil, silver and soybeans.

With commodity options, such as those on soybeans, it is important for the trader to have at
least a basic knowledge of the seasonal forces that drive that particular market. During certain
times of the year there tends to be shortages in the soybean market, for example, which
drives up the price. Without knowing when this is likely to happen an options trader would be
at a disadvantage against someone who knows that market.

Valuation of FX options and futures options

The two models that are most often used in the valuation of both FX and futures options are
the Black-Scholes model and the Garman-Kohlhagen model. As with stock options, volatility
plays a major role in the valuation of these two types of options.

The post FX and Futures Options Trading appeared first on Options Trading.