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jasperforex · 29-11-2004, 08:52

Soultrader2004 suggested I write something down about the subject to save me having to regurgitate it forever in the chatroom. Before I start I'd just like to say that I'm no expert in the field but I have been taught a few tricks/techniques/tips that make it easier to forecast fx and so make money from it.

You can go into a lot of detail but for the purposes of usefullness and simplicity, there are two types of options, vanilla and exotic. Vanilla options are basic/plain and simply give the right to buy/sell at a certain price at a certain time. Exotic options differ in that they may have certain conditions attached to them or they may be barriers instead. Barriers are basically options that payout if the strike has not been touched during the life of the option. Another example is a touch when the payout occurs if the price hits the strike during the life of the option.

Now the important bit. Options are only going to be useful to us if they are large/have a large payout. This is because it needs to be worthwhile to both counterparties to defend/trigger the option. Take this example. A bank sells a 1.35 one touch to a client for 5m dollars. This option expires in a weeks time has a payout of 25m dollars. Breaking it down it means bank has to fork out 25m to client if 1.35 is touched. It depends on the bank but average yearly returns for banks in the options market can be a few hundred million in good times, so the 25m would be a not insignificant dent to profits. So if the market starts to approach 1.35 the bank will start to sell euros in order to try to stop it touching 1.35 and triggering the payout. The client on the otherhand may be trying to force the market up and will be buying euros. The thing to remember here is that banks generally don't lose and 8 or 9 times out of ten, these kind of options won't pay out and instead the bank can simply bank the 5m premium paid to them as profit. To make money yourself from this kind of thing you can either short the market ahead of 1.35 or buy 1.35 puts the first few times the market approaches the barrier. You might wonder about 25m not sounding like a huge amount but it means that the bank can probably sell +5bn euros before it decides it's not worth defending the option anymore. Despite what people say about the total market size, whenever trades of even 1bn are heard of they often cap/hold the market for the day.

Another example. 1 yard 1.32 vanilla call expiring at NY cut today. NY cut occurs at 10am eastern time. Vanillas are simpler to understand in that you should consider big vanilla options as magnets. They draw the market to them. Taking the example. There would be a good chance that the market would be trading around 1.32 at 10am because at the 1.32 the option would not be worth anything and so the bank takes the premium as profit. This explaination isn't always the case but the explaination itself isn't important, only the effect is. And thats that vanilla options act as magnets. Now the important bit, how to benefit from it. If you know of some big options expiring tomorrow at 1.32 and the market is trading lets say around 1.31 to 1.3150 the evening before (or morning of the expiry day), you can buy a 1.3150/75 daily call option that expires either at the same time as the example or a bit later in the day (you can do these options at IG Index). That way if the big option comes into play and acts as a magnet, you will end up profiting.
Another useful thing about vanillas is that even if the market isn't trading at their strike price at the expiry, and instead its about 20 or 30 points away, it can still have the effect of a drag on the market, so after the expiry happens, you might find fresh money comes into the market and creates a good move. In the example (1 yard 1.32 call) the drag would have been to the downside if the euro was trading a bit above it, so come 10 am expiry, a wave of buying could occur as those on the sidelines waiting to buy step in.
For sure, this is not everything there is to know about these things but if you hopefully it gives people an incentive to do some research because it is useful stuff, just there's a lot of things that aren't important to know and that's what makes options so difficult to understand in total.

29-11-2004, 08:52	#1
jasperforex level 3 Join Date: Jul 2004 Posts: 304 Downloads: 0 Uploads: 0 Rep Power: 0	How to use options information Soultrader2004 suggested I write something down about the subject to save me having to regurgitate it forever in the chatroom. Before I start I'd just like to say that I'm no expert in the field but I have been taught a few tricks/techniques/tips that make it easier to forecast fx and so make money from it. You can go into a lot of detail but for the purposes of usefullness and simplicity, there are two types of options, vanilla and exotic. Vanilla options are basic/plain and simply give the right to buy/sell at a certain price at a certain time. Exotic options differ in that they may have certain conditions attached to them or they may be barriers instead. Barriers are basically options that payout if the strike has not been touched during the life of the option. Another example is a touch when the payout occurs if the price hits the strike during the life of the option. Now the important bit. Options are only going to be useful to us if they are large/have a large payout. This is because it needs to be worthwhile to both counterparties to defend/trigger the option. Take this example. A bank sells a 1.35 one touch to a client for 5m dollars. This option expires in a weeks time has a payout of 25m dollars. Breaking it down it means bank has to fork out 25m to client if 1.35 is touched. It depends on the bank but average yearly returns for banks in the options market can be a few hundred million in good times, so the 25m would be a not insignificant dent to profits. So if the market starts to approach 1.35 the bank will start to sell euros in order to try to stop it touching 1.35 and triggering the payout. The client on the otherhand may be trying to force the market up and will be buying euros. The thing to remember here is that banks generally don't lose and 8 or 9 times out of ten, these kind of options won't pay out and instead the bank can simply bank the 5m premium paid to them as profit. To make money yourself from this kind of thing you can either short the market ahead of 1.35 or buy 1.35 puts the first few times the market approaches the barrier. You might wonder about 25m not sounding like a huge amount but it means that the bank can probably sell +5bn euros before it decides it's not worth defending the option anymore. Despite what people say about the total market size, whenever trades of even 1bn are heard of they often cap/hold the market for the day. Another example. 1 yard 1.32 vanilla call expiring at NY cut today. NY cut occurs at 10am eastern time. Vanillas are simpler to understand in that you should consider big vanilla options as magnets. They draw the market to them. Taking the example. There would be a good chance that the market would be trading around 1.32 at 10am because at the 1.32 the option would not be worth anything and so the bank takes the premium as profit. This explaination isn't always the case but the explaination itself isn't important, only the effect is. And thats that vanilla options act as magnets. Now the important bit, how to benefit from it. If you know of some big options expiring tomorrow at 1.32 and the market is trading lets say around 1.31 to 1.3150 the evening before (or morning of the expiry day), you can buy a 1.3150/75 daily call option that expires either at the same time as the example or a bit later in the day (you can do these options at IG Index). That way if the big option comes into play and acts as a magnet, you will end up profiting. Another useful thing about vanillas is that even if the market isn't trading at their strike price at the expiry, and instead its about 20 or 30 points away, it can still have the effect of a drag on the market, so after the expiry happens, you might find fresh money comes into the market and creates a good move. In the example (1 yard 1.32 call) the drag would have been to the downside if the euro was trading a bit above it, so come 10 am expiry, a wave of buying could occur as those on the sidelines waiting to buy step in. For sure, this is not everything there is to know about these things but if you hopefully it gives people an incentive to do some research because it is useful stuff, just there's a lot of things that aren't important to know and that's what makes options so difficult to understand in total.