The advantage of buying options is the ability to create limited risk trades and strategies without having to utilize a stop-loss order, hence you avoid stop-outs (as long your MT4 account equity supports the option buy price). Furthermore, you risk is limited but your profit is unlimited.
Call and Put options on MT4 can be used to trade a currency pair’s direction. If you expect a pair to rise you may buy a Call option and if you expect a pair to fall you may buy a Put.
Two things you need to consider when buying options; the strike price and the expiry date. Through buying an option you are reserving a price in the market and that reserved price is known as the strike. A Call option’s strike is a reserved buy rate and a Put’s strike is a reserved sell rate. The value of an option depends on the market price level relative to the strike price. The more the strike can ‘beat’ the market the more the option is worth. Secondly, options with a longer expiry will cost more but they also give more time for your outlook to happen, this could be described as ‘buying more time’.
Trade an Uptrend – Buying a Call Option
You would buy a Call to trade an uptrend because a Call gives the owner the right to buy a currency pair at a certain market rate. This certain rate is the strike rate. Once you are holding the option, the more the strike can ‘beat’ the market the more valuable your option becomes.
For example, the image below shows a weekly (w) EUR/USD Call with a strike of 1.0900. If you buy this option you will hold the right to buy EUR/USD at 1.0900 until the end of the trading week. The option costs 0.00414 (Ask price) to buy. Note that, 0.00414 = 41.4 pips
If EUR/USD is trading above the strike rate by expiry the option will have value because your option is allowing you to buy at a better rate. Say, EUR/USD is trading at 1.1000, your strike of 1.0900 allows you to buy at a much cheaper rate (100 pips cheaper in fact!). The more the market rate rises above your strike the more valuable the Call option becomes.
When your options value is higher than the price you paid for it, you may sell it for a profit. On the other hand, if EUR/USD is trading below the strike rate at expiry, the Call option has no value and a loss is incurred. Your loss is limited to the price you initially paid for the option (in this case that is 41.4 pips).
In summary, as the market rate moves UP, above the strike rate, the Call option’s value increases and if the market moves DOWN, expiring below the strike, a loss is incurred.
The loss is limited yet the position cannot get stopped-out. This may be useful to trade a volatile uptrend.
Trade a Downtrend – Buying a Put Option
You would buy a Put to trade a downtrend because a Put gives the owner the right to sell a currency pair at the strike rate. If you are holding the Put option, the more your strike can ‘beat’ the market the more valuable your option becomes.
For example, the image below shows a weekly EUR/USD Put with a strike of 1.0800. It would cost you 0.00337 (33.7 pips) to hold the right to sell EUR/USD at 1.0800 until the end of the trading week.
If the market rate is below the strike rate by expiry, the Put option will have value because it allows you to sell at a better rate. Say, EUR/USD moved to 1.0700, you have the right to sell at the higher rate of 1.0800. The more the market falls, the more valuable the Put option becomes.
When your options value is higher than the price you paid for it, you may sell it for a profit. On the other hand, if EUR/USD is trading above the strike rate at expiry, the Put option has no value and a loss is incurred. Your loss is limited to the price you paid (in this case that is 33.7 pips).
In summary, as the market rate moves DOWN, below the strike rate, the Put option’s value increases and if the market moves UP, expiring above the strike, a loss is incurred. The loss is limited yet the position cannot get stopped-out. This may be useful during a volatile downtrend.
One of the challenges a new trader has to deal with is timing. We can get the direction of a trade right and still loss because our entry timing was wrong. With buying an option we can be a little more flexible. As long as the volatility hasn’t exploded and we are near the beginner of a new advance we could make a profit. For example, buying an option just as the currency is turning from a wave 2 into wave 3 could provide us with a potential big profit.
We know wave 3 in an Elliot Wave count cannot be the shortest and so trading this wave stacks the odds in our favour of a profitable trade.
The possibilities through buying options don’t stop there, they can also be used to trade strategies such as straddle and strangles allowing investors to take advantage of increases or decrease in market volatility. These will be explained in future articles.