First Principles

I am rather rusty on options, so forgive my ignorance, I'm not going to write any short hands in case I get them wrong, and I'm sure this is all obvious to anyone trading options regularly, but I would like to run something by you.

This is all my interpretation (I've read Hull, done a fair bit during my degree etc, but that is generally forgotten and I'm sort of looking at it fresh). I have probably missed something rather fundamental.

There are two (main) contributors to the price of an option.

1-Intrinsic value, value of the option for arbitrage. If our underlying is at 100, a call at 90 is going to be worth at least 10, otherwise arbitrage is possible (ignoring trading costs).

2-Time value, there is a possibility that the underlying will rise/fall, and so this chance needs to be included in the price. I have worded that awfully.

Anyway, observations:

1-Intrinsic value can always be calculated
2-option value = intrinsic value + time value.
1+2=>3-time value can always be calculated.
4-At expiry (or just before) the time value = 0 (no chance of the underlying moving).

So for a very basic and dare I say n00bish approach, selling the time value will [/massive air quotes] always [\massive air quotes] give a profit .

Of course, we can't just sell the time value, we have to sell the whole option. We can hedge to a certain extent by buying the underlying.

And here we come to the crux of the matter, I want to check I have accounted for all the risks of the following approach, I am fully aware that:

1-It is probably a stupid idea, and unlikely to work.
2-It has been done before.
3-It is not advised.

Really what I'm thinking of doing is selling an in the money call (there are lots of different ways to achieve the same/similar result I know, but I'm just keeping it simple for now), and buying the underlying at the same time.

For example, IG is currently quoting:

Bid on a call on Eur/Usd with strike of 139000 of 104.6. (15/10/10)
Ask on Eur/Usd of 13943

So the intrinsic value is 43.
Meaning the time value is 61.6

We buy Eur/Usd at 13943 and sell the call at 104.6

If price stays above the strike of 13900 until expiry, we make 61.6

Risks:

Increased volatility will increase the time value, which is not hedged.
Price falling below the strike price.
Spreads commissions etc.
Black swans f*cking everything up.

That is what I believe the risks to be, my question is: are there others?

You've pretty much covered all the bases, I would think... Just think of your trade as being short EURUSD puts, with all the risks that entails.

Ah cool, thought that was the case.

Cheers!

Hotch said:

Ah cool, thought that was the case.

Cheers!

Click to expand...

Have you done any basic due diligence on this trade? Specifically, looked at the time series of EURUSD vol (just ATM, for simplicity) to gauge what sort of mark-to-mkt loss you might experience? One the most important tricks with selling options is to make sure you're getting compensated sufficiently for the risk you're taking on...

I haven't, and tbh I wouldn't know how, that last sentence is golden and should be on the minds of lots more traders, it applies to all trading.

Btw, I'm not in the trade, I'm not considering it for anything more than experimenting and learning, I was just wanting to make sure I haven't made any stupid assumptions in my thoughts so far.

P.S. Martinghoul you're awesome.

Hotch,

if you want to check out EURUSD volatility, you can use the ticker EURUSDV1M:IND on the bloomberg website (might have to register) for 1m ATM Vols, 3M for 3m etc... also, if you subscribe to a data vendor, CBOE produce an index (ticker $EVZ) that uses the VIX methodology on FXE (eurusd ETF) options.

If the liquidity issues aren't a problem, you might find you can be more competitive this way. Also you could try and find out what the bloomberg generic price tickers are for calls / puts.

One last thing - check out SaxoTrader, They do ccy options also.

HTH

Thanks for that Gecko! Will deffo check it out.