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Intermediate Level: Chapter 1

Agenda

  • Multi-leg bullish and bearish strategies overview
  • Spreads (Credit spreads and debit spreads, Vertical call spreads, Vertical bull call spread, Vertical bear call spread, Vertical put spreads, Vertical bear put spread, Vertical bull put spread)

Multi-leg bullish and bearish strategies overview

You can trade FX options with simple strategies:

  • If you think the price of a currency is going to go UP, you can buy calls or sell puts.
  • If you think the price of a currency is going to go DOWN, you can buy puts or sell calls.

More sophisticated trading strategies combine multiple calls or puts or both that have different strike prices or different times to expiration or both. These strategies allow you to reduce the cost or hedge the risk of implementing your market view.

  • Strategies designed to profit when the price of the base currency RISES against the quote currency are spoken of as bullish or bull strategies. Traders who expect the price of a currency to rise implement bullish or bull strategies.
  • Strategies designed to profit when the price of the base currency FALLS are spoken of as bearish or bear strategies. Traders who expect the price of a currency to fall implement bearish or bear strategies.

Trading strategies that employ more than one option position are called multi-leg strategies. Multi-leg strategies include spreads, straddles and strangles.

Key Terms: BULLISH STRATEGIES | BEARISH STRATEGIES

Spreads

To implement a spread, a trader buys one option and sells another on the same underlying. Spreads can be categorized as vertical, horizontal or diagonal.

  • In a vertical spread, the option bought and the option sold has the same expiration date and different strike prices.
  • In a horizontal or calendar spread, the option bought and the option sold have the same strike price and different expiration dates.
  • In a diagonal spread, the option bought and the option sold has different strike prices and different expiration dates.

Key Terms: SPREAD

Credit spreads and debit spreads

Some spread strategies seek to profit from the payoff of long options. In these strategies, the long option has a higher market price than does the short option. Hence, at implementation, these strategies produce a debit to the trader’s account. They can be categorized as debit strategies.

Other spread strategies seek to sell one option, buy a cheaper option and, when both expire worthless, make a profit from the difference in their prices. At implementation, these strategies produce a credit to the trader’s account. They can be categorized as credit strategies.

Vertical call spreads

To implement a vertical call spread, a trader buys a call option at one strike price and sells a call option at a different strike price.

The options have the same time to expiration.

Vertical call spreads can grow out of either bullish or bearish views of where the price of a currency is likely to go.

Vertical bull call spread

A vertical bull call spread is likely to be profitable if the price of the underlying currency goes up.

To implement a vertical bull call spread, a trader buys a call option at one strike price and sells a call at a higher strike price. The trader profits so long as the currency price rises above the long option’s strike price by at least the amount of the difference between the premium paid for the long call and the premium received for the short call.

A vertical bull call spread’s maximum profit is reached if and when the price of the currency reaches the strike price of the short call. Above that level, the profit remains the same no matter how high the price of the currency goes.

A vertical bull call spread’s maximum loss occurs if the price of the underlying currency does not rise above the strike price of the long call. The spread’s maximum loss is the difference between the premium paid for the long call and the premium received for the short call.

Through his or her choice of strike prices, a trader can calibrate a bull spread to the bullishness of his or her view of where the price of the underlying currency is likely to go.

  • If the trader were wildly bullish on the currency, he or she would buy an out of the money call and might not sell a call at a higher strike price at all.
  • If the trader is strongly bullish, he or she might buy a near-the-money call and sell a call at a substantially higher strike price.
  • If the trader is moderately bullish, he or she might buy an at-the-money call and sell a call at a strike price he or she thinks the underlying currency is unlikely to reach.
  • If the trader is only slightly bullish, he or she might buy an in-the-money call and sell a call at a near-the-money or even at an in-the-money strike price higher than the long call’s strike price.

In formulating a vertical bull call spread, a trader’s objective is to buy a call that has a strike price that the price of the underlying currency is likely to exceed and to sell a call that has a strike price that the price of the underlying currency is unlikely to exceed.

Vertical bear call spread

A vertical bear call spread is likely to be profitable if the price of the underlying currency goes down.

To implement a vertical bear call spread, a trader buys a call option at one strike price and sells a call at a lower strike price. The trader receives more money for the lower-strike-price call he or she sells than he or she pays for the higher-strike-price calls that he or she buys.

So long as the option expires with the currency price below the short call’s strike price, the trader profits by the amount of the difference between the premium received for the short call and the premium paid for the long call.

The trader profits so long as the currency price does not rise above the short call’s strike price by more than the amount of the difference between the premium received for the short call and the premium paid for the long call.

With a vertical bear call spread, a trader’s maximum loss is equal to the difference between the long call’s strike price and the short call’s strike price plus the premium received for the short call minus the premium paid for the long call.

The more bearish a trader is, the lower he or she will want the strike price of the call he or she sells to be. With a moderately bearish view, for the short call, a trader might pick an at-the-money strike price. With a strong bearish view, a trader might pick a call that has an in-the-money strike price. The lower the short call’s strike price; the greater the premium the trader will receive.

The more risk averse a trader is, the closer he or she will want the strike price of the call he or she buys to be to the strike price of the call he or she sells.

With a successful bearish call spread, a trader’s profit is limited to the difference between the premium of the call he or she sells and the premium of the call he or she buys. For a given bearish view, a well constructed bear put spread might well have greater profit potential.

Vertical put spreads

To implement a vertical put spread, a trader buys a put at one strike price and sells a put at a different strike price.

The options have the same time to expiration.

Put spreads can grow out of either bearish or bullish views of where the price of a currency is likely to go, but are perhaps best suited to bearish market views.

Vertical bear put spread

A vertical bear put spread is likely to be profitable if the price of the underlying currency goes down.

To implement a vertical bear put spread, a trader buys a put option at one strike price and sells a put at a lower strike price.

The trader profits so long as the currency price drops below the long put’s strike price by more than the amount of the difference between the premium paid for the long put and the premium received for the short put.

A vertical bear put spread’s maximum profit is reached if and when the price of the currency reaches the strike price of the short put. Below that level, the profit remains the same no matter how low the price of the currency goes.

A vertical bear put spread’s maximum loss occurs if the price of the underlying currency does not fall below the strike price of the long put. The spread’s maximum loss is the difference between the premium paid for the long put and the premium received for the short put.

Through his or her choice of strike prices, a trader can calibrate a bear spread to the bearishness of his or her view of where the price of the underlying currency is likely to go.

  • If the trader were wildly bearish on the currency, he or she would buy an out of the money put and might not sell a put at a lower strike price at all.
  • If the trader is strongly bearish, he or she might buy a near-the-money put and sell a put at a substantially lower strike price.
  • If the trader is moderately bearish, he or she might buy an at-the-money put and sell a put at a strike price he or she thinks the underlying currency is unlikely to reach.
  • If the trader is only slightly bearish, he or she might buy an in-the-money put and sell a put at a near-the-money strike price or even at an in-the-money strike price lower than the long put’s strike price.

In formulating a bear put spread, a trader’s objective is to buy a put that has a strike price below which the currency is likely to drop and to sell a put that has a strike price below which the trader thinks the currency is unlikely to drop.

Vertical bull put spread

A vertical bull put spread is likely to be profitable if the price of the underlying currency goes up.

To implement a vertical bull put spread, a trader sells a put at a higher strike price and buys a put at a lower strike price.

The trader receives more money for the higher-strike-price put he or she sells than he or she pays for the lower-strike-price put that he or she buys.

If the currency price goes up and the puts expire with the currency price above the short put’s strike price, then the trader profits by the amount of the difference between the premium received for the short put and the premium paid for the long put.

So long as the currency price does not fall below the short put’s strike price by more than the amount of the difference between the premium received for the short put and the premium paid for the long put, the trader profits.

With a vertical bull put spread, a trader’s maximum loss is equal to the difference between the short put’s strike price and the long put’s strike price minus the premium received for the short put plus the premium paid for the long put.

The more bullish a trader is, the higher he or she will want the strike price of the put he or she sells to be. With a strong bullish view, a trader might pick a put that has an in-the-money strike price. With a moderately bullish view, for the short put, a trader might pick an at-the-money strike price. The higher the short put’s strike price; the greater the premium the trader will receive.

The more risk averse a trader is, the closer he or she will want the strike price of the put he or she buys to be to the strike price of the put he or she sells.

With a successful bullish put spread, a trader’s profit is limited to the difference between the premium of the put he or she sells and the premium of the put he or she buys and the risk is limited to the difference between the sell and buy strikes. For a given bullish view, a well constructed bull call spread might well have greater profit potential.

Summary

  • Multi-leg bullish and bearish strategies overview
  • Spreads (Credit spreads and debit spreads, Vertical call spreads, Vertical bull call spread, Vertical bear call spread, Vertical put spreads, Vertical bear put spread, Vertical bull put spread)

Next: Chapter Two

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