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Beginner Level : Chapter 3

Agenda

  • FX option profits and returns
  • Risk
  • Naked versus covered or hedged short option positions
  • Margin trading leverages potential gains— and losses
  • When you trade on margin
  • Margin requirements for FX options vary

FX option profits and returns

If an option produces a payoff that is greater than the original cost of the option, then the buyer of the option earns a profit.

If an option expires out of the money and worthless or if the payoff is less than the original cost of the option, then the buyer of the option experiences a loss.

If the payoff equals the original cost of the option exactly, then the buyer of the option breaks even.

The holding-period return on a long position in an option is given by the equation:

HPR = (Payoff – Cost of option) / Cost of option

Risk

The risk of loss that a long position in FX options creates is limited to the value of the options. Limited risk refers to the amount of loss but not the likelihood of loss.

If your options expire worthless, you lose the amount of money that you paid for them.

The risk of loss that a short position creates is quite different.

Selling FX call options creates a risk of loss that is uncapped.

If, for $0.25, you sell the right for the holder to buy a Euro from you at a strike price of $2 and, by the time the call expires, the market price of Euros has gone to $3, then you’ve lost $1 minus the $0.25 premium you received.

The higher the price of the base currency goes above the strike price, the more money you lose. In theory, when you are short call options, the risk of loss is unlimited.

The risk of loss that a short position in puts creates is ordinarily larger than the amount of premium you receive from the sale, but the risk is capped.

If, for $1, you sell a put that has a strike price of $20 dollars and the price of the underlying drops to $17, then you lose $20 – $17 + $1 = $2.

Selling a put creates a theoretical maximum risk of loss equal to the put’s strike price minus the sale price of the put.

If, for $1, you sell a put that has a strike price of $20 dollars and the price of the underlying drops to $0, then you lose $20 – $0 + $1 = $19. (Values of currencies rarely if ever drop to zero.)

Naked versus covered or hedged short option positions

When you go short calls or puts, you can either take other positions that limit the risk of the short position or not.

If you take other, offsetting or limiting positions, your short position is spoken of as covered or hedged.

If you take no offsetting or limiting positions, your short position is spoken of as naked.

When you go short call options, you can manage your risk in different ways.

You can buy the underlying currency and sell a like number of call options on it at a strike price at or higher than the price you paid for the currency.

If the currency price goes above the strike price, then you keep the premium you received for the option but forfeit to the call buyer the gain you would have gotten on the rise in value of the currency above the strike price. (Buying the underlying currency to cover the calls you sell limits your risk if the price of the currency rises, but if the currency falls in price, you suffer a loss on the value of the currency you hold.)

Alternatively, to limit your risk when you go short call options at one strike price, you can buy a like number of cheaper call options at a higher strike price. You gain the premium from the sale of the calls at the lower strike price. You pay the lower premium for the calls at the higher strike price. If the price of the currency rises, your net payout on the exercise of the calls you sold is limited to the difference between the two strike prices.

Similarly, when you go short put options, you can take offsetting positions that limit or hedge your downside risk.

In theory, when a trader goes short put options, he or she, at the same time, could go short a like amount of the underlying currency. But this is not a good risk-management strategy because, if the value of the currency rises, the trader has unlimited risk of loss from the short sale of the currency.

When going short a put, a more reasonable hedging strategy would be to buy another, cheaper put at a lower strike price. With this hedging strategy, the trader gains the difference between the two premiums. If the currency declines in price, the trader’s payout is limited to the difference between the two strike prices.

Key Terms: HEDGE

Margin trading leverages potential gains— and losses

Most dealers allow traders to trade on margin. That is, they lend you at interest a substantial portion of the money with which to purchase currencies and options.

Dealers may lend you as much as 50:1 on all major pairs and 20:1 on all minor pairs.

In general, buying financial assets on margin allows you to leverage your gains.

If, without margin trading, you paid $100 for a financial asset and the value of the asset then went up in value to $120, you would have a gain of $20. On your $100 investment, you would earn a holding period return of 20%.

If, through margin trading, you acquired a $100 financial asset through a $5 deposit to your margin account and the value of the asset then went up in value to $120, you would have a gain of $20. On your $5 investment, you would earn a holding period return of 400% (less the interest expense).

Trading on margin also leverages your risk exposure. You can lose 100% of your investment. You can lose even more than 100% of your investment.

If, without margin trading, you paid $100 for a financial asset and the value of the asset then went down in value to $95, you would have a loss of $5. On your $100 investment, you would have a holding period return of -5%.

If, through margin trading, you acquired a $100 financial asset through a $5 deposit to your margin account and the value of the asset then went down in value to $95, you would have a loss of $5. On your $5 investment, you would have a holding period return of -100% (less the interest expense).

If, without margin trading, you paid $100 for a financial asset and the value of the asset then went down in value to $80, you would have a loss of $20. On your $100 investment, you would have a holding period return of -20%.

If, through margin trading, you acquired a $100 financial asset through a $5 deposit to your margin account and the value of the asset then went down in value to $80, you would have a loss of $20. On your $5 investment, you would have a holding period return of -400% (less the interest expense).

When you trade on margin …

When you trade on margin, the financial assets you hold plus the equity in your margin account serve as collateral for the loan you receive from the dealer. They protect the dealer against losses on the loan.

When a dealer allows a trader to trade on margin, initial- and maintenance-margin requirements ensure that the trader—not the dealer— covers any losses.

In trading financial assets on margin in general, the securities you purchase on margin serve as partial collateral for the loan from the dealer. As additional collateral, a dealer requires that you deposit an initial amount of money into a margin account.

This money is called the initial margin. The required amount is expressed as a percentage of the cost of the currency or option.

Hence, your purchase of a security on margin gives your trading account an asset: the security valued at its market value, and a liability: the amount of the loan from the dealer. Your initial equity interest in the account is equal to the value of the asset minus the liability.

Equity = Asset – Liability

In other words, your initial equity interest in the asset is equal to your initial margin.

For example, to buy a financial asset priced at $100 on an initial margin of 5%, you deposit $5 to your margin account. You own an asset worth $100 and have a liability to the dealer of $95. (In reality, because of a dealer’s bid-ask spread and the difference between the ask price and the asset’s mark-to-market value, the asset will be valued at slightly less than $100.)

Equity = Asset – Liability
= $100 – $95
= $5

The equity and the asset serve as collateral for the liability.

After you purchase the asset, if the value of the asset goes below a certain level, then the dealer will require you to deposit additional money to your margin account. The amount of money you are required to maintain in your margin account after the initial purchase is called the maintenance-margin requirement.

For most financial assets, maintenance-margin requirements are expressed this way: If the equity in your account falls below X% of the market value of the assets you hold, then you must contribute more cash to the account until the equity is at least X% of the market value of the asset.

How does that work?

Equity in your margin account has two sources: your cash contributions to the account after the initial margin and gains on the market value of the assets you hold. Losses on the assets you hold reduce the equity in your margin account. Any cash withdrawals from your margin account also reduce your equity in the account.

If losses in the market value of the financial asset bring the equity in the account below the maintenance-margin requirement, then additional contributions to the margin account are required. The additional contributions bring your equity back up to the required level.

In the table below, we show the simplified purchase on margin of a financial asset at a price of $100. (We omit interest charges on the margin loan.) The initial margin requirement is 5%. The maintenance-margin requirement is 5%.

Using easy numbers, the value of the asset goes up and then, with one bounce, goes down to $0.

Read through the table day by day.

So long as the market value of the financial asset is above its initial value, equity as a percent of the asset’s market value is equal to or greater than 5%.

When losses take the equity in the account below 5% of the market value of the asset, contributions to the margin account are made sufficient to bring equity back up to 5% of the market value of the asset.

For example, look at the transition from day 9 to day 10. At the end of day 9, equity is $2. On day 10, the market value of the asset loses $20. The loss drops the equity from $2 to -$18. End-of-day-10 required equity is 5% of $20 or $1. To get equity from $18 to the required $1, a contribution to the margin account of $19 is required.

Day Market
Value
Contribution to
margin account
Liability Equity Equity as %
of Market Value
0
$100.00
Initial margin: $5.00
95.00
5.00
5%
1
$110.00
95.00
15.00
14%
2
$120.00
95.00
25.00
21%
3
$140.00
95.00
45.00
32%
4
$150.00
95.00
55.00
37%
5
$160.00
95.00
65.00
41%
6
$120.00
95.00
25.00
21%
7
$100.00
95.00
5.00
5%
8
$80.00
19.00
95.00
4.00
5%
9
$40.00
38.00
95.00
2.00
5%
10
$20.00
19.00
95.00
1.00
5%
11
$40.00
95.00
21.00
53%
12
$20.00
95.00
1.00
5%
13
$8.00
11.40
95.00
0.40
5%
14
$4.00
3.80
95.00
0.20
5%
15
2.00
1.90
95.00
0.10
5%
16
1.00
0.95
95.00
0.05
5%
17
0.40
0.57
95.00
0.02
5%
18
0.20
0.19
95.00
0.01
5%
19
0.10
0.0950
95.00
0.0050
5%
20
0.01
0.0855
95.00
0.0005
5%
21
0.00
0.0095
95.00
0.0000
Total Contribution: $100.00

In effect, the initial-margin contribution pays for 5% of the initial value of the asset. Subsequent maintenance-margin contributions pay for 95% of the value of losses from initial value. If losses total $100, then the initial margin contribution is $5 and maintenance-margin contributions total $95.

By the time the market value goes from $100 to $0.00, the trader has contributed a total of $100 to his or her margin account. The trader has lost $100.

If your equity falls below the maintenance-margin requirement and you do not contribute additional cash to your margin account as promptly as the dealer requires, then the dealer may sell all or a portion of your financial assets sufficient to meet the margin requirement.

In general, with the maintenance-margin requirement expressed as equity as a percentage of market value, if the market value of the financial asset goes to zero, then contributions to the margin account will have been made equal to the original cost of the financial asset. .

Margin requirements for FX options vary…

They depend on currency volatility and on the risk exposures of the combined positions you take.

Margin requirements for buying and selling FX options serve the same purpose as they do for trading other financial assets: The options plus the trader’s contributions to the margin account serve as collateral to protect the dealer from exposure to actual or potential losses that arise or may arise out of the option trades.

The risk of loss that the purchase of FX options creates is limited to the value of the options. Selling FX call options, however, creates a risk of loss that is, at least in theory, unlimited. (If, for $0.25, you sell the right to buy a Euro from you at a strike price of $2 and, by the time the call expires, the market price of Euros has gone to $1,000,002, then you’ve lost $1 million minus the $0.25 premium you received.) Selling a put option creates a theoretical risk of loss equal to the put’s strike price minus the sale price of the put. (If, for $1, you sell a put with a strike price of $20 dollars and the price of the underlying drops to $0, then you lose $20 – $1 = $19.

Dealers do not require traders to put up margin equivalent to the theoretical limits of options’ risk exposures. Instead, dealers examine likely potential one-day losses that option positions create.

When traders trade FX options and currencies, they frequently enter into a position that combines the purchase or sale of a currency with purchases and/or sales of multiple options.

To calculate initial margin requirement for an FX option trade that combines currencies and/or options and purchases and/or sales, a dealer runs the combined positions that the trade would create through sixteen different market scenarios. Different scenarios feature different combinations of increasing and decreasing currency price and increasing, decreasing and steady underlying currency price volatility. (The greater the volatility, the greater potential losses— and profits.)

For each scenario, the dealer calculates the potential one-day loss of the combined positions. The potential one-day loss of the scenario that produces the greatest one-day loss becomes the margin requirement for the trade combination into which the trader has entered.

Likewise, to calculate maintenance-margin requirements, each day a dealer runs a trader’s positions through sixteen different market scenarios. For each scenario, the calculator calculates the potential one-day loss of the positions. The potential one-day loss of the scenario that produces the greatest one-day loss becomes the margin requirement for the day.

Margin trading is a powerful tool. Use it accordingly.

Summary

    • FX option profits and returns
    • Risk
    • Naked versus covered or hedged short option positions
    • Margin trading leverages potential gains— and losses
    • When you trade on margin
    • Margin requirements for FX options vary

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