Forex Investment and Currency Trading

Options are characterized by an asymmetrical risk profile. This means that opportunities and risks are not shared equally between the buyer and the writer (seller).

• The risk for the option buyer is limited to the loss of the option price (premium) paid.
• The loss potential for the writer, on the other hand, is higher. When he writes a call, his risk of loss is unlimited. When he writes a put, it is limited to the amount of the strike price less the option price (premium) received.

Market price risk

Risk associated with changes in price of underlying (delta)
Options are fundamentally subject to the same market risks as their respective underlying asset. The absolute price risk associated with an option depends on the changes in the price of the underlying asset on which the option is based. If the price of the underlying asset rises, the value of a purchased call (put) rises (falls) accordingly. This is called delta risk. The delta of an option is a measure of how the market value of the option changes with marginal changes in the value of the underlying asset.

Risk associated with convexity (gamma)
If the value of the underlying asset changes, the changes in the value of the option cannot be explained by the option delta alone. The change in the value of the option may be over-proportionate or under-proportionate to the change in the price of the underlying asset. That is to say, the relationship between the price of the option and the price of the underling may not be linear but shaped as a convex curve. This is known as convexity or gamma risk. Gamma is a measure of how the value of an option changes as its delta changes.

Please note: Option prices not only reflect changes in the price of the underlying asset but may also develop a price momentum of their own compared with the price of their underlying asset. This inherent momentum of option prices, given a particular strike price, is due in particular to the following parameters and other price-determining factors:

• Changes in the volatility of the underlying asset,
• fluctuations in the risk-free interest rate, and
• reduction of the remaining term of the option.

All other conditions being equal, the following relationship apply, and the following risks of loss may arise.

Risk associated with changes in volatility (vega)
 Decreases in volatility cause the value of both purchased all options and purchased put options to fall. This volatility risk or vega risk is a broad measure of the change in the value of an option with a change in (anticipated or implied) volatility of the price of the underlying asset. This means that changes in volatility can reduce the value of an option, even though the price of the underlying asset remains constant, rises (in the case of a call) or falls (in the case of a put).

The enormous effect of volatility is illustrated in the following example of an index call option with a strike price of 5,700 and three months remaining term:

This means that if volatility drops by three percentage points, the index must rise by 88 points (or 1.6%) in order to avoid sustaining a loss on the option. Expressed another way, with this drop in volatility and no change in the level of the underlying index, the price of the call option drops by 27.70 points (27%).

Risk associated with remaining term (theta)
A reduction in the remaining term of the option results in a drop in the market value of both a call and a put option. This drop in market value is particularly pronounced towards the end of the term of the option. This risk, called theta risk, is a measure of the change in the value of an option as a function of this remaining term.

Risk associated with changes in interest rates (rho)
If the risk-free interest rate rises, the value of a purchased call rises, whereas the value of a purchased put falls. This risk associated with the market level of interest rates, called rho risk, affects the discount rate used for calculating future cash flows and the opportunity costs of holding a spot position (cost of carry).

Ex-dividend markdown
In the case of options on shares, an ex-dividend markdown on the underlying shares during the remaining term of the option leads to a drop in the price of calls, while puts gain in value.

Please also note that the above-mentioned risk parameters (delta, gamma, vega, rho and theta) only apply to movements of price-determining variables one at a time and therefore provided no information on how the price of an option changes as these variables move simultaneously.

To allow quantification of the effect of the aforementioned individual factors (spot price, volatility, risk-free interest rate and the remaining term) on the value of the option, an option valuation model suitable for the respective underlying asset must be used. These models may be analytical, such as the Black-Scholes model, or numerical, such as the Cox-Rubenstein model. However, it should be noted that these models are partly based on extremely restrictive assumptions and are based on probabilistic methods, such that potential market risks cannot be predicted with certainly.

Risk of a drop in value or total loss

The rights under an option may expire worthless or drop in value because options always provide only limited rights which are additionally linked in part to the occurrence or non-occurrence of a condition. The shorter the period (remaining term), the greater is the risk of a loss in value.

Drop in value
If the price of an option during its term does not perform as anticipated, the holder may suffer a loss when closing out his position. Because of the limited term, it cannot be assumed that the value of the option will recover in time, i.e. before the end of its term.

Total loss
The purchase of an option may suffer a total loss of the premium paid solely because of unfavorable market developments or the lapse of time until option expiry.