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Options have an expiry date, beyond which they cannot be exercised. The premium consists of the intrinsic value and the time value (e.g., the more in the money it is, and the more distant expiry, the more valuable). Another important element in option pricing is volatility. The higher the implied volatility (and therefore probability of the option ending in-the-money (ITM), the higher the premium will be. The topic of option pricing is very complex, and it was only after Black-Scholes-Merton (BSM) created their model that option pricing gained objectivity (if not accuracy- there are many unrealistic assumptions in their model).

The BSM model uses 5 main variables which they named from the Greek alphabet- three of which are very

important:

Delta- how the option value changes as the underlying

Gamma- the first derivative, or velocity, of Delta

Theta- how fast the option loses value with time,

Vega- what effect a change in the underlying volatility affects the option value,

Rho- interest rate effects) is less important to traders, having only a second degree effect on option value.

Options and Forex- a perfect marriage

The usually high volatility of Forex lends itself very well to options. Once an option is in the money (ITM), the

value moves nearly 1:1 (excepting the time value) with the spot. Our downside risk is limited to the premium

already spent (if we avoid being net short options). No further drawdown to your account is possible. No matter

what the spot does, we can sleep at night.

Another advantage is that the need for stops is moot- if the spot moves away from the strike, the option value

drops. However, as long as there is still time value, if the spot recovers, so does the value of the option. This is a

key advantage of options- short term price action does not imperil our equity.

1) Choosing the Strike Price

We can buy ITM, ATM or OTM options. Generally, if the option is ITM or close to it, you’ll pay for excess

delta- but a higher probability of finishing ITM. We must integrate multiple factors for this decision. First, is the volatility high enough? Second, are there underlying fundamental changes that will drive it to some level (say to Purchasing Price Parity), and Thirdly, mean reversion.

2) Choosing the Expiry date

Obviously, the more distant the expiry, the more probability of profit (but you will pay for the excess theta).

To maximize your profitability (or minimize the loss if the option expires worthless), at a minimum, we

should calculate and analyze our estimate of the future volatility of the underlying, to determine if there is

a good chance for the spot to move far enough to make the option ITM.