How to use options information

[jasperforex]

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 so make money it.

You can go into a lot of detail but for the purposes of usefullness simplicity there are two types of options vanilla exotic. Vanilla options are basic/plain 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 triggering the payout. The client on the otherh may be trying to the market up will be buying euros. The thing to remember here is that banks generally don't lose 8 or 9 times out of ten these kind of options won't pay out instead the bank can simply bank the 5m premium paid to them as profit. To make money yourself 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 underst 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 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. thats that vanilla options act as magnets. Now the important bit how to benefit it. If you know of some big options expiring tomorrow at 1.32 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 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 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 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 that's what makes options so difficult to underst in total.

[Gamma_Jammer]

Good post Jasper - about time someone jotted this stuff down for the benefit of any newbies who ask.

However as things st unless you regularly 'bump' this thread to the top of the pecking order it's gonna be lost in a few weeks. Can I therefore suggest the moneytec administrators consider making it sticky?

GJ

[jackwallaby]

Thanks Jasper what you have described has me in total amazement that a bank will try to sell down the option (if close to the mark) before expiry I did not think that the action by the bank could influence the price before expiry It would take some courage at that point by the bank in question. I would suggest that most strikes are set well beyond the banks expectation to actualy pay at expiry? Thanks all the same that is helpful information definately requires more research on my part.

[jasperforex]

Sure Gamma I'll mention it to Soultrader2004 as he's a moderator in chat so he'll get the message across.
Jack I'm not sure about how they write their options but obviously they must set out to write that expire worthless. Just sometimes they will get it slightly wrong sail a bit close to the wind so "measures" need to be taken to avoid a loss.

[Hamant]

Dear JasperForex

Came across your thread today funilly as I am a newbie on forex I ran into Rapd Forex Site they have an ebook apparently which gives you some sort of software which exploits this Options pricing so you can take advantage of where the price is likely to move.
Have you coem across this Site if you have I wonder if you can tell me if the course is any good at all.

Hamant

[garyh]

JasperForex

Thanks for the post. Where would a trader go to find out about options that might be expiring such as the you've described?

Gary

[jasperforex]

Hamant I can't say I've heard of it sorry. All I can say is the best way to learn is by someone showing you real time. My options work came as part of a home course where they sit with you go through stuff that's important.
Garyh I use broker news feeds check as many news feeds as I can. Berkeley Futures used to be brilliant but not long ago they changed their news provider so now they don't have as much info you have to have more than one source now.

[Rhody Trader]

Jasper

The points you make regarding the attraction of the market toward a big strike price are valid can come in very hy when the markets are trading near those points.

Here's a more accurate depiction of what's going on though.

When banks buy or sell options most of the time they are going to hedge or completely offset those positions. They are not taking naked one-sided bets. That's not their game. The hedging can take a number of paths.

One very common path is the delta hedge in which the bank uses the option delta (in essense the % likelihood of the option being triggered) to establish a hedge position. As the market moves the delta will change which means the bank will be adjusting their position according. If the bank has sold an option based on the market reaching a higher level their delta hedge would involve being long in the spot market. As prices rise - increasing delta - they will be d to buy more in the spot market to keep their hedge in line. This is a part of the attraction toward the strike. The bank's own activity to a certain degree is self-fullfilling. This is in fact the exact opposite of defending a strike.

I used to work in the fx options spot markets. There was always a lot of chatter about big expiries important strike prices. Most of the time it amounted to very little. The fact of the matter is you can't know how big any strike really is given that the market is primarily inter-bank commercials can play a big role as part of their hedging operations.