Understanding Put Options A Beginner's Guide for Forex Traders
A common belief is that trading is simply buying low and selling high. However, there is a way to profit when prices go down, and that is with put options. A put option is a contract that gives you the right (but not the obligation) to sell an asset or stock at a certain price and date. You could think of a put option as insurance that pays if prices drop. Just like call options give you the right to buy, put options give you the right to sell.
Everyday scenario: You are selling a used textbook. You agree to sell the book for $50; however, the market price drops to $40. You have effectively used a put option, because a price of $50 has been locked in while the market price dropped.
Where Put Options Come From
Put options aren't some modern financial gimmick. They've been around for centuries, evolving in addition to the markets. The idea of options originated in the 17th-century Dutch tulip market, when traders utilised rudimentary option agreements during the tulip mania phenomenon. Then, options evolved to being more organised in the 18th and 19th centuries through the introduction of futures contracts, based mainly on commodities like wheat and cotton.
The revolution occurred when standardisation set in. Early options were bespoke agreements between two parties and were difficult to trade or exit. However, as markets matured, the exchanges developed standardised contracts with a fixed strike price, expiration date and size of contract.
Put Options Across Different Trading Styles
Professional example: There are generally around 50 pips of daily movement in the EUR/USD currency pair. A day trader may buy a put option to take advantage of a 20-pip decline. The asset price may be at 1.1000, and the day trader targets the decline to 1.0980.
Simple example: You buy and sell used textbooks in between classes. You buy in the morning, and then by lunchtime, you attempt to have realised the profit of $5 by selling the textbook immediately once you reach your target profit.
The Psychology of Put Options
The market won't care about your feelings, but your feelings matter when it comes to trading. Put options accentuate the psychological challenges because you're literally betting against the market, which is tougher psychologically than trading the direction of the market.
A trader purchases a EUR/USD put option at 1.1000, with a target at 1.0900. The market declines to 1.0950, and they have the option up 50 pips (and could be better off had they traded it down). They think, "It's going down fast, I'll get to 1.0900," and hold on to the 50 pip option. But the market rallies back to 1.0980, and they take the option off for 20 pips instead of the 50 pips they had at one point.
How to Set Realistic Put Option Targets
Support and resistance levels: These are prices that have proven troublesome for the market to pass through historically. If the EUR/USD is showing strong support at 1.0950, then the put option target should be set at 1.0940 (which is just below support).
Technical indicators: Some of the other tools, such as Bollinger Bands and Fibonacci retracement levels, provide a way to estimate the area in which the fall in price may occur. For example, the lower Bollinger Band will let you in on where the price may find temporary support as the security heads lower.
Putting It All Together
Targets are established scientifically: Different situations will create different price targets, but you will need to determine the odds on the risk-reward ratio if you wish to get paid, while utilising technical analysis and market volatility (ATR). And before you enter any trade, you must check the economic calendar for high-event news, which is important.
Execute with discipline: I recommend pre-planning your entry, target and stop loss before entering into any type of trade will maximise your overall success. I recommend even encouraging use of automated entry and exit orders to take the emotion out of it. Keep a trading journal to look back for patterns. Remember, there is a time and place for emotion, and trader duties require you to be unemotional and disciplined to your plan to be successful long term.
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