Forex, Futures & Option Basics: Chicago-NW Burbs Trading Club. Nick Fosco Sep 1, 2012

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1 Forex, Futures & Option Basics: Chicago-NW Burbs Trading Club Nick Fosco Sep 1, 2012

2 Agenda: Forex Market Futures Market Options Part 1 Networking Break Options Part 2

3 Forex Market Currency pair trading 24 Hr market 4 PM CDT Sunday to 4 PM CDT Friday High liquidity High leverage Exchange rate valuation

4 Forex Market Exchange rate example: US dollar to Euro EUR/USD rate : $1 USD = 1 euro * rate = euros If rate increases > get more per $ less $ per Id rate decrease > get less per $ more $ per Make or lose money as rate changes

5 Forex Market No Commissions!! No minimum balance But has a spread Reserves ~ 1% Each increment = 1 pip EUR/USD pip = ,000 pips = $1.00

6 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 Oil & other commodities Gold & other metals Interest & currency rates Grains, livestock, stock indexes more

7 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 Quantity, quality, place & time do not change Highly liquid High leverage 24 hr / 5 day per week market

8 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 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)

9 STOCKS VS. OPTIONS VS. FUTURES Minimum acct. balance to day trade Stocks Options Futures $25,000 $25,000 As low as $500, TD is $5,600 (depends on broker) Leverage Between 0x Around 15x 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

10 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 per tick, and trading hours, expiration dates Know these before considering trading a specific future

12 /XXY# FUTURES NAMING FORMAT 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: June 2012 S&P e-mini = /ESM12

13 Commodity Futures TYPES OF 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. Interest Rates 30 year Treasury bond, 10 year, etc. Weather Cooling, Heating, Hurricanes, Snowfall, etc. Note: Not available on TOS

14 HOMEWORK: MORE INFORMATION Education tab Courses Find more information on: - Investing, Bonds, Funds, Options, Futures & Forex

15 WHAT ARE OPTIONS? Options are: Contracts Giving the buyer the right to: 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

16 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

17 TERMINOLOGY Holder: Buyer (has a long position) Option buyers have rights Long Calls: the right to buy 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

18 FOUR BASIC POSITIONS CALL PUT Buyer (long) Right to buy Right to sell Seller (short) Obligation to sell Obligation to buy

19 WHY OPTIONS Options can be considered insurance policies Put options can insure stock holdings - puts allow you to fix a selling price Call options can insure cash holdings - calls allow you to fix a buying price

20 IMPORTANT TERMINOLOGY Underlying Typically 100 shares of the stock on which the right or obligation exists. Example: XYZ December shares of XYZ stock is the underlying of this option

21 IMPORTANT TERMINOLOGY Strike or Exercise Price Price at which the underlying may be bought or sold Example: XYZ December $80 per share is the price at which the buyer of this call has the right to buy 100 shares of XYZ stock.

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

23 IMPORTANT TERMINOLOGY Premium The price of an option that is paid by the buyer and received by the seller. Example: XYZ December $5.50 per share, or $550 per option, not including commissions, is paid by the option buyer and received by the option writer.

24 IMPORTANT TERMINOLOGY Exercise Buyers invoke their rights Call Exercise: Call buyers choose to buy stock at the strike price (from the call seller) Put Exercise: Put buyers choose to sell stock at the strike price (to the put seller)

25 IMPORTANT TERMINOLOGY Assigned Being called upon to fulfill an obligation. 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.

26 INTRINSIC VALUE AND TIME VALUE Stock Price = $56.00 Price of 50-strike Call Option = 8.00 Time Value = 2.00 Stock Price = 56 Strike Price = 50 Intrinsic Value = 6.00 Option Premium (or Price) = 8.00

27 Networking Break Next up is more on OPTIONS!!!

28 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

29 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

30 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 value Example: With a stock price of $60 The 60 Call is at-the-money It has no intrinsic value

31 OPTION PRICING COMPONENTS Insurance Premium asset value deductible term of policy cost of money (interest) risk assessment Stock Option Premium current stock price strike price time to expiration cost of money (interest & dividends) volatility forecast

32 OPTION PRICING Inputs: Stock price Strike price Time until expiration Cost of money (interest rates less dividends) Volatility (a measure of risk) Outputs: Call and Put Premiums

33 TYPES OF VOLATILITY Historical Actual 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

34 Option Strategy Order Entry Call Option String Put Option String

35 BUY CALL Strategy View Expect market to rise significantly in short-term. Strategy Implementation Call options bought at strike price of a More bullish investor is, higher the strike price. Upside Potential Profit potential unlimited; rises with market. Breakeven Point at Expiry Strike price plus premium Downside Risk Limited to premium paid -incurred if the market at expiry is at, or below, the strike a Margin Not required

36 BUY PUT Strategy View Expect market to fall significantly in short-term. Strategy Implementation Put option bought at strike price of a More bearish investor is, lower the strike price. Upside Potential Profit potentialis unlimited (market can not fall below zero). Breakeven Point at Expiry Strike price minus premium paid. Downside Risk Limited to the premium paid -incurred if at expiry the market is at or above the strike a Margin Not required

37 SELL CALL Strategy View Expect market to not rise unconcerned whether it will fall. Strategy Implementation Call 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 Potential Limited to premium received -received if the market at expiry is at, or below, the option strike. Downside Risk Unlimited Losses as the market rises. [Can limit risk with bear spread]. Margin Always required

38 SELL PUT Strategy View Sure market will not go down; unconcerned about whether it will rise. Strategy Implementation Put options sold at strike price a. Bullish investor would sell in-the-money puts. Upside Potential Profit potential limited to premium received. The more the option is in-the-money, the greater the premium received. Breakeven Point at Expiry Strike price less premium Downside Risk Loss almost unlimited. Potential of huge losses if market crashes. Margin Always required

39 BULL SPREAD Strategy View Think market will rise, but wants to cap the risk. Conservative strategy Strategy Implementation Call 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 Limited in both cases Calls: Difference between strikes minus debit Puts: Net initial credit Downside Risk Limited in both cases Calls: Net initial debit Puts: Difference between strikes minus credit Margin Possibility for margin requirements to be off-set

40 BEAR SPREAD Strategy View Think market will fall, but wants to cap the risk. Conservative strategy Strategy Implementation Call 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 Limited in both cases Calls: net initial credit Puts: difference between strikes minus debit Downside Risk Limited in both cases Calls: difference between strikes minus credit Puts: net initial debit Margin Possibility for margin requirements to be off-set

41 OTHERSPREADTYPES Straddle Strangle Buy or Sell both the options at same strike price Buy Long Straddle Sell Short Straddle Buy or Sell both the options at different strike prices Buy Long Strangle Sell Short Strangle

42 LONG BUTTERFLY Strategy View Think market will be flat, want to cap downside risk. Strategy Implementation Buy 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 Limited to difference between lower and middle strikes minus the net debit of spread Downside Risk Limited to the initial net debit of spread Margin Margin could be possible.

43 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 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.

Market Strategies. Navin Bafna Investment Banking Jan 2008

Market Strategies. Navin Bafna Investment Banking Jan 2008 Market Strategies Using Options Navin Bafna Investment Banking Jan 2008 SEGMENTS CAPITAL MARKET CASH FUTURES & OPTIONS FUTURES OPTIONS ONE TWO THREE MONTH CALL PUT OPTIONS CALL PUT CALL PUT The buyer of