In the Money, At the Money, and Out of the Money

In placing an option trade, the center of attention for the forex trader is on where the spot forex price is. The spot price is called the at-the-money strike price. Whenever a call or put option is purchased, the strike price is either in the money (ITM), at the money (ATM), or out of the money (OTM). Options can also be deep in the money
and deep out of the money. The term moneyness refers to this relationship of the option price to the at-the-money price.

Since there is no “free lunch” in trading, the trader has a range of choices in putting on an option trade regarding increasing the probability of success. The most likely option strategy for success is buying an in-the-money option position. This means that he will get the maximum movement of the option with the spot. Once a position is in the money, it moves on a 1:1 basis with the spot. The advantage of an in-the-money option versus a spot position is that it will cost the trader only the premium and no other risk is associated with it. The disadvantage is that the premium costs a lot more.

The next type of trade relating to moneyness is the at-the-money option. This is when the option strike price is where the spot is. This kind of positioning allows the trader to be close to the action without paying as much as the in-the-money option. ATM options are very common in hedging a position. ATM options move with the spot at 50
percent of the movement. This is called a delta factor and will be discussed in more detail shortly.

The out-of-the-money option trade is the most popular trade. Let’s see why: By selecting a strike price that is away from the spot, the trader is anticipating the move. The hope of the forex trader is, of course, that the price will (during the duration of the option trade) move toward the strike price or exceed it. The option trader makes money
by being right not only if the spot price actually moves to and beyond the strike price at expiration, but whether along the way it is expected to move in the direction of the price.

The objective is trying to use all the tools that are available to increase the probability of being right about the direction of the option trade about market expectations, and about its timing.

DIAGNOSING GLOBAL ECONOMIC CONDITIONS

Generally, the forex trader needs to anticipate the economic growth of the country or region associated with the currency. There are many locations to access up to date data on economic growth. Foremost among them is the central banks themselves. Once again, it is a question of timing. Economies move in cycles and take time to slow down or turn around. This is an area of great ambiguity for the forex trader. The trader has four decision rules:

1. Trade with the current economic cycle.
2. Trade a slowing down of economic growth.
3. Trade a stagnant economy.
4. Trade a growing economy.

If economic growth is projected to be slowing down, then the probability of the central bank’s increasing rates must be considered as declining. Central banks do not increase rates when growth is slowing down.
Also, the trader needs to consider the time frame for the option. The longer the time frame, the greater the risk of being wrong. But a longer time frame allows time for fundamentals to work out and express themselves in the price action. The forex option trader chooses a longer time frame to allow for countertrend moves to occur and then resume a fundamental direction. So, whether a forex option trade should be one week or several months is very much a judgment call. However, there are fundamental criteria for choosing a time of duration that should be considered. Depending on the economic conditions, forex option trades can range from very short term to longer term. Basically, a 3-month duration for an option trade will allow a reasonable period of time for fundamental forces
to express themselves.