Forex Investment and Currency Trading

As the writer of an option, you assume the obligation, in the case of a call, to make delivery of the underlying asset to the buyer if the buyer exercises his option, or likewise in the case of a put, to take delivery of the underlying asset from the buyer at the agreed price. You as the writer thus bear the risk of a rise (in the case of a call) or a drop (in the case of a put) in the price of the underlying asset. If the option stipulates physical delivery (e.g. of shares), then you may have to acquire the underlying asset insofar as you do not already hold it. In the case of cash settlement, you must pay the agreed amount in cash to the buyer of the option.

Counterparty risk

Counterparty risk refers to the risk of insolvency arising from the weak credit quality of a counterparty to a contract and primarily affects OTC option contracts. In addition, only those options for which exercising the option makes, or will in the future make, economic sense are subject to this credit risk.

Since you as the buyer of an option must generally pay an option premium upon execution of the trade, the result is that, whereas the seller of an option is not exposed to any credit risk after receiving the premium, the buyer of an option has to bear the entire credit risk. Once you have paid the premium, you immediately face the risk of the counterparty defaulting on his obligations. Market movements increase or reduce this risk of the counterparty defaulting on his obligations. Market movements increase or reduce this risk. If the counterparty defaults but you have already closed out the position, you incur the costs of replacing this contract. These costs are, at best, zero. They are made up of the intrinsic value of the option and its time value.

Risk associated with leverage

Like delta, leverage refers to the change in the price of an option as the price of the underlying asset or instrument changes. In contrast to delta, though, leverage describes the percentage rather than the absolute price change of the option relative to changes in the price of the underlying. However, since this price elasticity may only be measure after the fact, leverage is estimated using the so-called “leverage factor”.

The leverage factor is essentially a multiple of the potential profit or loss potential which the holder of the option would have if the same amount of capital were directly invested in the underlying asset. The leverage factor can be calculated quite easily using one of the following methods:

Leverage factor = price of underlying / option price

The leverage factor determined in this way is also called gearing factor. It only provide a rough indication, as it considers only changes in the intrinsic value of the option with changes in the underlying asset and does not consider the change in time value as the remaining term of the option shortens. For this reason, the leverage factor using this method will overstate the amount of leverage for options which are out of the money. For options which are deeply in the money, in contrast, the leverage factor computed in this way is quite accurate.

In practice, in order to make the leverage factor more meaningful, this difference in price behavior is taken into account by multiplying the out-of-the-money options, which are relatively low-priced, and in-the-money options, which are relatively high-priced, by the option delta.

Leverage factor = (price of underlying / option price) x delta

By bring delta into the formula, the leverage is adjusted to consider changes in the time value of the option.

The magnitude of the leverage factor depends on several factors. Options with longer (shorter) remaining terms display lower (higher) leverage. If an option has a high (low) intrinsic value, the leverage effect will generally be small (large). Options with a minimal remaining term and / or low intrinsic value are thus associated with a high risk of loss.