Forex, Futures & Option Basics:

Chicago-NW Burbs Trading Club

Nick Fosco

Sep 1, 2012

Agenda:

• Forex Market• Futures Market• Options Part 1

• Networking Break

• Options Part 2• Options Part 2

Forex Market

• Currency pair trading

• 24 Hr market – 4 PM CDT Sunday to 4 PM CDT Friday

• High liquidity

• High leverage• High leverage

• Exchange rate valuation

Forex Market

• Exchange rate example: US dollar to Euro

• EUR/USD rate : 1.2144

• $1 USD = 1 euro * 1.2144 rate = €1.2144 euros• If rate increases > get more € per $

• less $ per €• less $ per €• Id rate decrease > get less € per $

• more $ per €

• Make or lose money as rate changes

Forex Market

No Commissions!! No minimum balance

But has a spreadBut has a spreadReserves ~ 1%

Each increment = 1 pipEUR/USD pip = .0001

10,000 pips = $1.00

Futures Market

• Futures contracts are legally binding agreements• Delivery of commodity or financial product• At an agreed to future date

• Derives value from underlying product

• Provide access to wide variety of investments• Provide access to wide variety of investments• Oil & other commodities• Gold & other metals• Interest & currency rates• Grains, livestock, stock indexes• more

Futures Market

• Created to help reduce price risk to:• Growers, producers & manufacturers

• Establish sale prior to delivery of goods

• Provides and exchange to connect buyers & sellers

• Only variable per future contract is price• Only variable per future contract is price• Quantity, quality, place & time do not change

• Highly liquid

• High leverage

• 24 hr / 5 day per week market

Futures Market

• Contracts held to expiration are entitled to receipt of goods

• Most contracts are sold prior to expiration• Avoid need to take delivery

• Futures traders are mainly speculators, hedgers & commodity producerscommodity producers

• Margin account is required to trade futures

• Opening a futures position is similar to stocks

• Commissions are per contract

• Tax benefits: 1256 Contract (40% ST gains, 60% LT gains)

STOCKS VS. OPTIONS VS. FUTURES

Stocks Options Futures

Minimum

acct.

balance to

day trade

$25,000 $25,000 As low as $500,

TD is $5,600

(depends on broker)

Leverage Between 0x

and 2x

Around 15x

for ATM

Between 8x and 87x

and 2x for ATM

option

Equivalents 500 shares 10 ATM calls 1 future contract

Capital

gains: day

trading

100% short

term

100% short

term

1256 contracts =>

40% short term 60%

long term

FUTURES BASICS

� Futures trade on margin

� Initial margin amount is set by the exchange and is

subject to change

� Example: ES is set by CME at $5,625 per contract

� Each future has a different tick amount, dollar value � Each future has a different tick amount, dollar value

per tick, and trading hours, expiration dates

� Know these before considering trading a specific future

FUTURES NAMING FORMAT

� /XXY#

� XX = Symbol name

○ S&P 500 e-mini = ES

� Y = month code

○ March =H, June = M, September = U, December =Z

� # = last digit of the year

○ 2012 = 12

� Example: � Example:

� June 2012 S&P e-mini = /ESM12

TYPES OF FUTURES

� Commodity Futures

� Gold, Corn, Wheat, Oil, Natural Gas, etc.

� Index Futures

� S&P 500, Dow, NASDAQ, Russell 2000, FTSE, Nikkei, etc.

� Forex Futures

Euro, Pound, Yen, Aussie, etc.� Euro, Pound, Yen, Aussie, etc.

� Interest Rates

� 30 year Treasury bond, 10 year, etc.

� Weather

� Cooling, Heating, Hurricanes, Snowfall, etc.

� Note: Not available on TOS

HOMEWORK: MORE INFORMATION

Education

tab

Find more information on:

- Investing, Bonds, Funds, Options, Futures & Forex

Courses

WHAT ARE OPTIONS?

Options are:

•Contracts

•Giving the buyer the right to:

• Buy or sell an underlying asset• Buy or sell an underlying asset

(e.g., 100 shares of specified common stock)

• At a fixed price (the strike price)

• On or before a given date

TERMINOLOGY

•Call: Gives investor the right to ‘call in’

(buy) an asset.

• Profit when underlying rises in price.

•Put: Gives investor the right to ‘put out’

(sell) an asset.

• Profit when underlying drops in price

TERMINOLOGY

•Holder: Buyer (has a “long” position)Option buyers have rights

�Long Calls: the right to buy

�Long Puts: the right to sell�Long Puts: the right to sell

•Writer: Seller (has a “short” position)Option writers have obligations

�Short Calls: the obligation to sell

�Short Puts: the obligation to buy

FOUR BASIC POSITIONS

Right to buy

Right to sell

CALL PUT

Buyer(long)

buy sell

Obligation to buy

Obligation to sell

(long)

Seller(short)

WHY OPTIONS

Options can be considered insurance policies

•Put options can insure stock holdings- puts allow you to fix a selling price- puts allow you to fix a selling price

•Call options can insure cash holdings- calls allow you to fix a buying price

IMPORTANT TERMINOLOGY

•Underlying Typically 100 shares of the

stock on which the right or obligation exists.

Example:

XYZ December 80 Call @ 5.50

100 shares of XYZ stock is the “underlying”

of this option

IMPORTANT TERMINOLOGY

•Strike or Exercise Price Price at which

the underlying may be bought or sold

Example:

XYZ December 80 Call @ 5.50

$80 per share is the price at which the

buyer of this call has the right to buy 100

shares of XYZ stock.

IMPORTANT TERMINOLOGY

•Expiration Date The day on which the option ceases to exist. Typically, the expiration date is the Saturday following the third Friday of the expiration month.

Example:

XYZ December 80 Call @ 5.50

The Saturday following the third Friday in December is the expiration date of this option.

IMPORTANT TERMINOLOGY

•Premium The price of an option that is

paid by the buyer and received by the seller.

Example:Example:

XYZ December 80 Call @ 5.50

$5.50 per share, or $550 per option, not

including commissions, is paid by the option

buyer and received by the option writer.

IMPORTANT TERMINOLOGY

•Exercise Buyers invoke their rights

• Call Exercise: Call buyers choose to buy stock at the strike price (from the call seller)strike price (from the call seller)

• Put Exercise: Put buyers choose to sell stock at the strike price (to the put seller)

IMPORTANT TERMINOLOGY

Assigned Being called upon to fulfill an

obligation.

Call Assignment Call sellers are randomly chosen and Call Assignment Call sellers are randomly chosen and

are required to sell stock at the strike price to the call

buyer.

Put Assignment Put sellers are randomly chosen and

are required to buy stock at the strike price from the

put buyer.

INTRINSIC VALUE AND TIME VALUE

Stock Price = $56.00

Price of 50-strike Call Option = 8.00

Time Value

Strike Price = 50

Option Premium (or

Price) = 8.00Intrinsic Value

= 6.00

Time Value

= 2.00

Stock Price = 56

Networking BreakNetworking Break

Next up is more

on OPTIONS!!!

THE IN’S AND OUT’S OF OPTIONS

In-The-Money Calls:

• Stock price is above strike price

• In-the-money calls have intrinsic value

Example:

With a stock price of $63

The 60 Call is in-the-money by $3

It has $3 (per share) of intrinsic value

THE IN’S AND OUT’S OF OPTIONS

Out-of-The-Money Calls

•Stock price below strike price

•Out-of-the-money calls do not have

intrinsic value

Example:

With a stock price of $63

The 65 Call is out-of-the-money by $2

It has no intrinsic value

THE IN’S AND OUT’S OF OPTIONS

At-The-Money Calls:

•Stock price equal to strike price

•At-the-money calls do not have intrinsic

valuevalue

Example:

With a stock price of $60

The 60 Call is at-the-money

It has no intrinsic value

OPTION PRICING COMPONENTS

Insurance

Premium

• asset value

Stock Option Premium

• current stock price• asset value

• deductible

• term of policy

• cost of money (interest)

• risk assessment

• current stock price

• strike price

• time to expiration

• cost of money (interest & dividends)

• volatility forecast

OPTION PRICING

Inputs:

•Stock price

•Strike price

•Time until expiration

•Cost of money (interest rates less dividends)•Cost of money (interest rates less dividends)

•Volatility (a measure of risk)

Outputs:

•Call and Put Premiums

TYPES OF VOLATILITY

• HistoricalActual volatility during a specified time period (ATR)

• Future

Actual volatility from present to option expiration

• Implied

Volatility that justifies an option’s current

market price

• Forecasted

Estimate of future volatility used in computer

models to calculate theoretical values

Call OptionString Put Option

OptionStrategy

String Put OptionStringOrder

Entry

BUY CALL

� Strategy ViewExpect market to rise significantly in short-term.

� Strategy ImplementationCall options bought at strike price of ‘a’More bullish investor is, higher the strike price.

� Upside PotentialProfit potential unlimited; rises with market.

� Breakeven Point at ExpiryStrike price plus premium Strike price plus premium

� Downside RiskLimited to premium paid - incurred if the market at expiry is at, or below, the strike ‘a’

� MarginNot required

BUY PUT� Strategy View

Expect market to fall significantly in short-term.

� Strategy ImplementationPut option bought at strike price of ‘a’More bearish investor is, lower the strike price .

� Upside PotentialProfit potential is unlimited (market can not fall below zero).

� Breakeven Point at ExpiryStrike price minus premium paid. Strike price minus premium paid.

� Downside RiskLimited to the premium paid - incurred if at expiry the market is at or above the strike ‘a’

� MarginNot required

SELL CALL� Strategy View

Expect market to not rise unconcerned whether it will fall.

� Strategy ImplementationCall option sold at strike price of ‘a’If very certain then at-the-money options sold. If less certain, then out-of-the-money sold.

� Upside PotentialLimited to premium received - received if the market at expiry is at, or below, the option market at expiry is at, or below, the option strike.

� Downside RiskUnlimited Losses as the market rises. [Can limit risk with bear spread].

� MarginAlways required

SELL PUT� Strategy View

Sure market will not go down; unconcerned about whether it will rise.

� Strategy ImplementationPut options sold at strike price ‘a’. Bullish investor would sell in-the-money puts.

� Upside PotentialProfit potential limited to premium received. The more the option is in-the-money, the greater the premium received. greater the premium received.

� Breakeven Point at ExpiryStrike price less premium

� Downside RiskLoss almost unlimited. Potential of huge losses if market crashes.

� MarginAlways required

BULL SPREAD� Strategy View

Think market will rise, but wants to cap the risk. Conservative strategy

� Strategy ImplementationCall option bought at strike price of ‘a’ and Call option sold at strike of ‘b’, net debit.or

Put option bought at strike of ‘a’ and Put option sold at strike of ‘b’, net credit.

� Upside Potential� Upside PotentialLimited in both cases Calls: Difference between strikes minus debitPuts: Net initial credit

� Downside RiskLimited in both cases Calls: Net initial debitPuts: Difference between strikes minus credit

� MarginPossibility for margin requirements to be off-set

BEAR SPREAD� Strategy View

Think market will fall, but wants to cap the risk. Conservative strategy

� Strategy ImplementationCall option sold at strike price of ‘a’ and Call option bought at strike of ‘b’, net credit.or

Put option sold at strike of ‘a’ and Put option bought at strike of ‘b’, net debit.

Upside Potential� Upside PotentialLimited in both casesCalls: net initial credit Puts: difference between strikes minus debit

� Downside RiskLimited in both casesCalls: difference between strikes minus creditPuts: net initial debit

� MarginPossibility for margin requirements to be off-set

OTHER SPREAD TYPES

Straddle

� Buy or Sell both the options

at same strike price

� Buy – Long Straddle

Strangle

� Buy or Sell both the options

at different strike prices

� Buy – Long Strangle

Sell – Short Strangle� Sell – Short Straddle � Sell – Short Strangle

LONG BUTTERFLY

� Strategy ViewThink market will be flat, want to cap downside risk.

� Strategy ImplementationBuy call option with low strike ‘b’Sell two call options with medium strike ‘a’Buy call option with high strike ‘c’(The same position can be created with puts, but is less common).

� Upside Potential� Upside PotentialLimited to difference between lower and middle strikes minus the net debit of spread

� Downside RiskLimited to the initial net debit of spread

� MarginMargin could be possible.

SHORT BUTTERFLY

� Strategy View

Investor mildly thinks that the market will be volatile.

� Strategy Implementation

Sell call option at strike ‘b’

Buy two call options at strike ‘a’

Sell call option at strike ‘c’

[Similar position can be created with puts].

� Upside Potential� Upside Potential

Limited to initial credit received.

� Downside Risk

Limited to the difference between the lower and middle strikes minus the initial spread credit.

� Margin

Off-set may be available.