By Sean Hyman As you know, I’m a Forex guy, through and through. I spend my days watching the Forex charts and skimming pips off my favorite currency pairs.

But before I was a Forex trader, I first traded stocks professionally and then later I traded options. So I’ve ran the gamut when it comes to investing.

In the years since I hung up my options trading hat, there have been some serious developments in the options market – especially when it comes to currencies. Specifically, the Chicago Mercantile Exchange and Philadelphia Stock Exchange (now known as the NASDAQ OMX) both offer options on specific currencies.

Since 2007, the Philadelphia Stock Exchange has offered a special type of currency option that trades exactly like regular stock options. This exchange now offers option contracts on 10 different currencies as of earlier this month.

Why does this matter? If you’re a long-term investor, then currency options are one of the few ways I’ve found that you can still shoot for larger profits. Currency option investors often hold contracts for weeks or months at a time. I’ve also watched option investors earn 100%, 200% even 300% on their contracts.

I’ve written about options here in FX University before, so if you’d like a little more background information on how options work, please view my last article.

But today, I want to take you one step further. I want to share with you my number one secret to buying currency options, so you can shoot for the bigger gains. In reality, the secret to successfully trading options all comes down to time…

The Critical Difference Between Time Value & Intrinsic Value

An option itself is simply a contract that gives you the right to buy or sell a specific asset at a specific price (known as the “strike price”). Options are known as “wasting assets.” This means they have an expiration date and options drop in price as that expiration date approaches.

An option’s expiration date affects its pricing. When any options are priced, they have two main components to their pricing. 1. Intrinsic value and 2. Time value.

First let’s take a quick look at intrinsic value. This is simply the amount that your option is “in the money.” By this, I mean your option has already reached its strike price. Any amount past the strike price is called the intrinsic value.

Here’s an example just to be clear. Let’s say you thought the euro would rise in price. So you bought a euro call option with a strike price of $0.50. However, the price is now up to $0.75. Since your call option is over the strike price (or “in the money”) by $0.25, this means your option has an intrinsic value of $0.25.

Now that’s only ONE piece of the option’s pricing.

Another major component is your option’s time value. This one is easy because it’s simply the cost of your option minus the intrinsic value.

Let’s stick with that previous example that has a $0.25 intrinsic value. If you paid $2.00 for your option and $0.25 of that price is intrinsic value, then the remaining $1.75 is the time value.

What’s the basic thought behind “time value” that makes the price what it is? Frankly, it’s a complex formula, but the premise is pretty simple…

What You Need to Know Before You Buy a Single Option

Say you’re about to buy a call option. You have two different choices…

1. You can buy a call option with a strike price of $50, and a current price of $40 that expires next month.
2. You can buy the very same call option with a strike price of $50 and a current price of $40 too, BUT your option expires six months from now.

Which option should you choose to buy? Answer: The ones that give you more time.

Here’s why: You have to look at what’s more likely to happen. Is it more likely that your call option will gain $10 and earn more than its strike price in the next 30 days, or anytime in the next six months? Of course the latter…so that’s why a longer expiration date carries a higher “time value.”

Side note: Your option’s price erodes as your option gets closer to its expiration date. That’s the “time value” portion of your option’s price. That’s why many traders will buy option contracts far away from the expiration date so the “time value” erodes slowly. This way, they get more bang for their buck then by buying an option that’s about to expire.

So the “time until expiration” is one of the components of how the “time value” piece of the equation is priced. Another aspect of the option’s price is of course the volatility that the market expects out of the underlying financial asset.

The More Likely to Hit Your Strike Price, the More You Pay

Here’s another truth you need to learn about options: The greater the chance you’ll hit your strike price, the more you pay for that option.

Also, the higher the volatility, the higher the option’s price because there’s a greater chance of you exceeding your strike prices than if you were buying a low volatility option.

Therefore, GBP/USD would have a higher premium generally, than the USD/CAD because it doesn’t normally move as fast (isn’t as volatile generally) as that of GBP/USD.

This is why you shouldn’t necessarily choose an option because it is “cheap.” Cheap options are a “shot in the dark” and that’s why they are cheap.

Expensive options are that way because they have a huge likelihood of actually making it well past their strike prices.

Bottom line: Options are a very savvy way to buy currencies over the long run, but pay attention to their pricing. Just because they’re “cheap” doesn’t necessarily make them a bargain.

Happy Trading!
Sean Hyman, aka Professor FX

P.S. Get the inside track on which currency options you should be buying over the next six months. Click here for details.