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Intermediate Level : Chapter 3

Agenda

  • Beyond Spreads: Straddles and Strangles
  • Straddle
  • Strangle
  • Going short versus going long in spreads, straddles and strangles
  • Types of orders (Market orders, Stop orders, Limit orders, Order type durations for GTC, EOD and GTW, Contingent orders, OCO: One cancels the other)

Beyond Spreads: Straddles and Strangles

Straddles and Strangles are a trading style to trade either on or against volatility.

The names “straddle” and “strangle” provides clues about these option positions. These positions are on both sides of the price move. Long straddles and strangles make money if the currency price moves up or down significantly.

  • Long Straddles and strangles are both options strategies that allow the trader to gain on significant moves either up or down in a currency’s price.
  • Short straddles and strangles allow the trader to gain on a lack of significant move in a currency’s price.

Both strategies consist of buying an equal number of call and put options with the same expiration date; the only difference is that the strangle has two different strike prices, while the straddle has one common strike price. As a general rule, traders prefer to sell straddles and buy strangles when the expiration date is far in the future; conversely, they prefer to buy straddles and sell strangles when expiration is in the near future.

Key Terms: STRADLES | STRANGLES

Straddle

If a trader expects a currency to make a large move one way or the other but doesn’t know which, he or she may wish to establish a straddle.

To implement a straddle, the trader buys a put and a call that have the same strike price and the same time to expiration.

If, at expiration, the price of the underlying has gone up or down by more than the combined cost of the two options, the trader will profit. The trader’s maximum potential loss is the cost of setting up the straddle.

In theory, if a trader believed that, over a given time horizon, the price of a currency was unlikely to go up or down, he or she could sell a straddle.

With a short straddle, however, a trader’s risk exposure would be unlimited on a rise in the currency’s price and, on a fall, equal to the difference between the put’s strike price and the proceeds from the short positions.

Strangle

If a trader expects a currency to make a large move one way or the other but doesn’t know which, he or she may wish to establish a position very similar to a straddle called a strangle.

To implement a straddle, the trader buys a put and a call that have the same time to expiration and the same strike price. To implement a strangle, the trader buys a put and a call that have the same time to expiration but different strike prices.

  • If the call has a higher strike price than the put, then, if, at expiration, the price of the underlying currency is between the two strike prices, both the call and the put will expire worthless.
  • If the put has a higher strike price than the call, then, at expiration, at least one of the options will be in the money.

Setting up a strangle in which the call has a higher strike price than the put is cheaper than setting up one in which the put has a higher strike price than the call.

The maximum possible loss is the cost of setting up the strangle.

  • If, at expiration, the price of the underlying is above the strike price of the call by more than the cost of setting up the strangle or below the strike price of the put by more than the cost of setting it up, then the strangle will be profitable.

Going short versus going long in spreads, straddles and strangles

The above descriptions of spreads, straddles and strangles; their payoffs characteristics and their risk characteristics assume that the trader takes long positions in the strategies. Alternatively, if a trader has market views opposite of those described as motivations for taking the long positions, he or she can take short positions in any of these strategies.

In a short implementation, the risk and payoff characteristics are the reverse of those of a long implementation.

If a long implementation produces a net debit, then a short implementation will produce a net credit— and vice versa.

If a long implementation creates a limited risk exposure for the trader and unlimited risk for the counterparty, then a short implementation will create an unlimited risk exposure for the trader and a limited risk exposure for the counterparty— and vice versa.

Types of orders

Traders may place market orders, stop orders or limit orders.

Market orders

A dealer fills a trader’s market buy order immediately at the prevailing ask price.

A dealer fills a trader’s market sell order at the prevailing bid price. With a market order, execution is not contingent on price. Even so, traders who place orders through electronic trading systems will ordinarily know the price at which they are buying or selling FX option contracts.Slippage may occur.

Key Terms: MARKET ORDER

Stop orders

With stop and limit orders, the trader specifies the price that will trigger execution of the order.

When a trader places a stop sell order, he or she specifies a price. If the market price of the currency or option specified in the order drops to or below the stop price, the stop sell order becomes a market sell order. The dealer executes the order at the best available price (which may or may not be the price specified).

Similarly, when a trader places a stop buy order, he or she specifies a price. If the market price of the currency or option specified in the order rises to or above the stop price, the stop buy order becomes a market buy order. The dealer executes the order at the best available price (which may or may not be the price specified).

Traders often use stop orders to limit the losses of existing positions. They also may issue stand alone stop orders. Placing contingent may not necessarily limit your losses.

Buy stop orders are triggered if and when the market price rises to the price specified. Sell stop orders are triggered if and when the market price falls to the price specified. Once triggered, a stand-alone buy or sell stop order becomes a market order.

If stop orders are never triggered, they are never executed.

Key Terms: STOP ORDERS

Limit orders

When a trader places a limit buy order, he or she specifies the maximum price he or she is willing to pay. If, when the order is placed, the dealer’s ask price is at or below the limit price, the dealer will fill the order at the limit price or lower. Or, if, before the limit order is canceled, the dealer’s ask price drops to the limit price, the dealer will fill the order at that price. If, before the order is canceled, the dealer’s ask price never drops to the limit price, the order is never filled.

When a trader places a limit sell order, he or she specifies the minimum price he or she is willing to accept for a currency or option. If, when the order is placed, the dealer’s bid price is at or above the limit price, the dealer will fill the order at the limit price or higher. Or, if, before the limit order is canceled, the dealer’s bid price rises to the limit price, the dealer will fill the order at that price. If, before the order is canceled, the dealer’s bid price never rises to the limit price, the order is never filled.

Traders may use limit sell orders either to specify a lower limit on how much they are willing to accept for a currency or option or to trigger sales automatically if market prices rise to attractive levels. Slippage may occur.

Order type durations for GTC, EOD and GTW – When you place a stop or limit order, it may not be executed right away. If the price of the underlying never reaches the price you specify, the order will never be executed. Hence, when you place a stop or limit order, you specify how long the order is to remain in effect.

  • GTC, good ‘til canceled, means you want the order to stay in effect either until it is executed or until you cancel it.
  • EOD, end of day, means you want the order to stay in effect until the end of the trading day and, if it is not executed by then, to be canceled.
  • GTW, good the week, means you want the order to stay in effect until the end of the trading week and, if it is not executed by then, to be canceled.

Key Terms: LIMIT ORDERS

Contingent orders

When you open a position, you can use contingent stop and limit orders to instruct the dealer to close the position if the price of the underlying falls or rises to a price you specify.
When you create a market, stop or limit order, simultaneously you also can initiate a contingent stop or limit order— or both. The contingent order or orders go into effect if and when the primary order is executed. That is, they are contingent upon the primary order being executed.

When you create a contingent stop or limit order, you specify the price at which the contingent order is to be triggered.

  • If, along with your primary order, you place a contingent stop order and the price of the underlying drops to the price you specify in the contingent stop order, then the dealer will close the position you established with your primary order.
  • If, along with your primary order, you place a contingent limit order and the price of the underlying rises to the price you specify in the contingent limit order, then the dealer will close the position you established with your primary order.

OCO: One cancels the other

If, along with your primary order, you place a contingent stop order and a contingent limit order and either contingent order is executed then automatically the other contingent order will be canceled.

Summary

  • Beyond Spreads: Straddles and Strangles
  • Straddle
  • Strangle
  • Going short versus going long in spreads, straddles and strangles
  • Types of orders (Market orders, Stop orders, Limit orders, Order type durations for GTC, EOD and GTW, Contingent orders, OCO: One cancels the other)

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