Help understanding OPTIONS

Beginner Questions
1

I understand the concept of an option, and what it means to buy calls and puts.

What I don’t understand is taking the other side of that deal, i.e. [I]selling[/I] calls and puts.

If you buy a put, you’re buying the right to sell at a fixed price, which has a lot of upside and minimum downside. That means the seller of the put has the obligation to buy at a fixed price IF the put is exercised. So the upside of that deal is that he gets a small premium if his position pans out, but if it doesn’t, the downside is that he suffers large losses by buying the pair for less than it’s worth. So why would anyone want to sell an option? Seems that the downside outweighs the upside.

As usual I suspect that I’m just misunderstanding some fundamental aspect of how the market works. Can anyone clear it up?

2

Hi there,
I believe this forum is for FOREX traders to discuss and sharing their trading ideas, opinions etc. I think you got in wrong place to talk about options.

Regards,

3

I assumed that trading FOREX options would fall under the heading of FOREX trading but I apologize if I’m mistaken.

4

Hi There,

Options is not something we worry about particularly in the spot forex world but if you are interested in understanding a bit more then I will be happy to try and help

There are basically 4 different types of trades when you talk about options. these are

Buying a Call (a long call)
Selling a Call (a short call)
Buying a Put (a long put)
Selling a Put (a short put)

If you are a speculator then you will genreally use the long versions of puts and calls. I’ll use wheat as an example.

You think that the price of wheat is going to go up, the current price is 100 and you think that the price will rise to 150 by July. You can purchase an option to buy wheat for a quoted price (the strike price) and all you have to do is hand over a premium for the pleasure of holding that option. Come July if the price has risen and is greater than the strike price on your option and the premium you paid (need to add both together) then you will make a profit.

for example

Long Call for July Wheat
*Current Price of Wheat = 65
*Strike/Excercise Price for July Wheat = 80
*Premium Paid = 5
*Come July (or anytime prior if it is an American style option) if the price of wheat is greater than 80+5 (strike price plus premium) then you can excercise the option and you will make a profit e.g. if price rose to the expected 150 figure then your profit would be 150-(80+5) = 65 profit
*If the price of wheat fell then your loss is purely limited to the premium that you paid (5)

If you think the price is going to fall instead of rise then the process is the same except you purchase a long put and you can apply the same methodology as above (but just in reverse)

Now then… In order for you to buy these puts and calls there must be someone who is willing to be on the other end of the trade, and this can be a very risky business as losses can be huge! (in fact in the case of selling a call losses could be unlimited)

Selling calls and puts are generally only done by large financial companies or comercial companies who own the actual product in question. The best outcome for them being on this end of the deal is that the price does not rise (if you are buying a call) above the strike price. If the price does not rise then they will only make back the premium that was paid for the option. If however the price does rise above the strike price + the premium then they will lose money. As price could theoretically rise an unlimited amount then their losses could actually be unlimited. This is slightly different for the sellers of puts (short puts) where the maximum profit that they can take is again the premium however price can only reach zero so their loss is then limited to the strike price minus the premium paid.

Have a look at the image I quickly drewup which shows a seller of a calls possible profit and loss. It is not to scale as I am sure you can see but it hopefully gives you the right idea.

Untitled.jpg700×409 11.6 KB

The best comparison I can make is that sellers of calls and puts are similar to insurance companies. e.g. they receive a relativley small premium to insure your risk however if you where insuring your house and it burnt down then they would be extremley out of pocket.

Anyway that is the best that I can do to try and explain it, hope it helps but it really doesn’t have that much to do in dealing in spot forex which is what this forum is mostly aimed at.

Regards

DT

5

THANK YOU daft!

6

One thing to remember most option expire worthless that is why a trader may want to sell them when I sell option I buy one options further out so I can define my risk the premium will be smaller but my risk is well defined, I find that adjustments may be needed to the trade about 2 out of 12 months. I trade this strategy monthly as an income generator strategy.