Trading ISE FXoptions:

A look at USD/GBP

relationship using verticalspreads

BPX

Steve Meizinger

ISE Director of Education

For the sake of simplicity, the examples that follow do not take intoconsideration commissions and other transaction fees, taxconsiderations, or margin requirements, which are factors that maysignificantly affect the economic consequences of a given strategy.An investor should review transaction costs, margin requirements andtax considerations with a broker and tax advisor before enteringinto any options strategy.

Options involve risk and are not suitable for everyone. Prior to buyingor selling an option, a person must receive a copy of

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or selling an option, a person must receive a copy ofCHARACTERISTICS AND RISKS OF STANDARDIZED OPTIONS.Copies have been provided for you today and may be obtained fromyour broker, one of the exchanges or The Options ClearingCorporation. A prospectus, which discusses the role of The OptionsClearing Corporation, is also available, without charge, upon requestat 1-888-OPTIONS or www.optionseducation.org

Any strategies discussed, including examples using actual securitiesprice data, are strictly for illustrative and educational purposes andare not to be construed as an endorsement, recommendation orsolicitation to buy or sell securities.

Outline

• Brief description of ISE FX options

• What are spreads?

• Debit, credit spreads defined

• Why an investor would use debit or credit spreads?

• The risk and reward of debit and credit spreads

• How can debit spreads be implemented using ISE FX options?

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• How can debit spreads be implemented using ISE FX options?

• Some potential trades in BPX

• Summary

Foreign currency market

• The FX market is the largest and most liquid market inthe world

• The currencies are traded in pairs, investors buy thedesired currency and sell the other currency

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• The cash or spot market is available for the variouscurrencies, a new trading alternative is the FX optionsmarket

ISE FX options are based on per US$

• Using the ISE FX options trading convention, the U.S.dollar is listed first, the valuation is expressed as thenumber of the units of the other currency per U.S.dollar.

• This trading convention makes it easy to remember, if

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• This trading convention makes it easy to remember, ifyou are bullish on the USD an investor could buycalls, if an investor is bearish the investor could buyputs

ISE FX option offerings (Oct 3)

• USD/EUR (ticker symbol, EUI) 72.30(0.7230 x 100)

• USD/GBP (ticker symbol, BPX) 56.24(0.5624 x 100)

• USD/JPY (ticker symbol, YUK) 105.87

(105.87 x 1) the rate modifier is 1 for JPY

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(105.87 x 1) the rate modifier is 1 for JPY

• USD/CAD (ticker symbol, CDD) 107.97(1.0797 x 100)

• USD/CHF (ticker symbol, SFC) 112.97

(1.1297 x 100)

• USD/AUD (ticker symbol, AUX) 128.91

(1.2891*100)

How do I make my FX forecasts?

• If you are concerned about too much financial exposure to acertain currency an option hedging strategy may be appropriate

• Or, if an investor has a view on a specific currency, the investormay want to “pair” that currency with another currency with thereverse view (CDD, EUI, BPX, YUK, SFC and AUX)

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• If you are familiar with equity options, think of currencies as amacro-economic view, rather than the micro-economic view forindividual equities

• What do you think about the US dollar/British pound currently(EUI), are you bullish, bearish or neutral?

Features Of ISE FX Options

• Options on exchange rates• U.S. dollar based• .50 strike prices• Premium quoted in U.S. dollars• European Exercise• Cash-settled• Noon Settlement/Option Friday• Noon Buying Rate FRB of NY

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• Noon Buying Rate FRB of NY• Available in a conventional U.S equity brokerage account• Continuous Two-Sided Quotes• Trading Hours 9:30 – 4:15 EST

Views on FX can be implemented at ISE

• Using ISE cash settled FX options your views on FXcan be easily implemented through the using of manyof the familiar options strategies including using debitor credit spreads

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Why Trade FX options?

• You can make a forecast on any of the SEC approved currencypairs and place the appropriate trade using ISE FX options

• For example, if you feel the U.S. economy is weak and willweaken and the British economy is strong and will furtherstrengthen you can execute that forecast using ISE cash settledFX options. Of course, you can execute the exact oppositeforecast also!

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forecast also!

• Or, an investor desires to hedge a particular currency risk

• Unlike most markets where you buy something outright, FX youare always buying one currency and selling another (currencypair)

Options create choices

• Options allow investors the ability to forecast their views of theforeign exchange market with limited risk

• Calls, or call spreads can be purchased if you are bullish on BPX(USD/GBP)

• Puts, or put spreads can be purchased if you are bearish on BPX

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• Puts, or put spreads can be purchased if you are bearish on BPX(USD/GBP)

• Debit spreads are defined as buying the strike price with morevalue (lower strike call or higher strike put) and selling the strike

price with less value (higher strike call or lower strike put)

Credit spreads too

• Credit spreads allow investors a limited risk method of attemptingto profit by selling options

• Credit call spreads could be implemented if you are bearish onthe USD/GBP

• Credit put spreads could be implemented if you are bullish on the

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• Credit put spreads could be implemented if you are bullish on theUSD/GBP

• Credit spreads are defined as selling the strike price with morevalue (lower strike call or higher strike put) and buying the strike

price with less value (higher strike call or lower strike put)

Views on FX can be implemented at ISE

• Using ISE cash settled FX options your views on FXcan be easily implemented through the use of manyof the familiar options strategies.

• The ISE now offers exchange traded options on theUS dollar/ Canadian dollar exchange rate

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• US dollar/British pound *100 = BPX

• If you are bearish on the USD/GBP rate simply buyputs if you are bullish on the USD/GBP buy calls

Spreads defined

• The simultaneous buying and selling of at least two options withdifferent strike prices. The objective is to profit from thechanging relationship of the spread itself

• The goal for a debit spread is for the spread to widen to themaximum amount (the difference between the two strikes), atexpiry this will yield the maximum profit. The maximum loss islimited to the debit paid for the spread

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limited to the debit paid for the spread

• The goal for credit spread is for the spread to narrow to zero,however the maximum loss on a credit spread is the width of thespread less any premium received for the initial credit trade

Why trade spreads?

• Spread trading offers unique tradeoffs– Investors can hedge their volatility risk and their time decay

risk if they so choose to

– The trade off for reducing those risks is that you cap yourpotential gains at the strike price sold

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• This is true for both credit spreads and debit spreadsalthough the process for calculating the maximum profitand maximum risk for the debit or credit spread strategyis different

Types of vertical spreads

• Bull call (debit spread)

• Bear call (credit spread)

• Bull put (credit spread)

• Bear put (debit spread)

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Let’s first concentrate on debit spreads

• The most an investor can lose on a debit spread is the initialdebit paid

• Bull call spread- Buy the lower strike call and sell the higherstrike call with the same expiration month as a hedge

• Bear put spread- Buy the higher strike put and sell the lower

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• Bear put spread- Buy the higher strike put and sell the lowerstrike put with the same expiration month as a hedge

Why use debit spreads?

• An investor would like to implement a price forecast, and would also liketo possibly reduce their time decay and volatility risk

• The use of spreads allows for a pre-defined risk

• Unique tradeoffs are created by buying one option and selling anotheroption as a hedge

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• Hopefully the spread will widen after it is sold and the investor can earna profit

• The ultimate goal is to earn the maximum profit for the debit spreadwhich can earned at the higher strike call or the lower strike put atexpiration

The use of debit spreads

• Debit spreads can be used by investors looking toreduce their risk of the purchased option by selling ahigher strike call (or a lower strike put) as a hedge

• A full understanding of the strategy is very important

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• Most importantly the debit spreads strategy shouldcomplement your overall market forecast

Complementing your forecast with the appropriate debit spread strategy

• If an investor is bullish on BPX- Bull call spreads maybe the preferred debit spread strategy

• If an investor is bearish BPX- Bear put spreads maybe the preferred debit spread strategy

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• Remember BPX is calculated as follows:– USD/GBP *100

– If the USD is rallying, BPX will be increasing

– If the USD is sliding, BPX will be falling

Risk and reward of debit spreads

• The maximum profit can be earned at the strike price sold atexpiration

• Maximum profit for a debit spread can be calculated as follows:the difference between the strike price less any premium paid forthe spread is the debit spread buyer’s maximum profit

• The maximum profit can only be earned if the underlying

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• The maximum profit can only be earned if the underlyinginstrument closes at or above the higher strike sold at expiration(calls) or at or below the lower strike price sold at expiration(puts)

Risk and reward of debit spreads

• The maximum risk of buying a debit spread is the premium paidfor the debit spread

• If the underlying closes at or below the strike price purchased(for calls) the investor can lose their debit paid for debit callspreads

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• If the underlying closes at or above the strike price purchased(for puts) the investor can lose their debit paid for debit putspreads

And now let’s focus on credit spreads

• The most an investor can lose on a credit spread is thedifference in strike prices less any premium received

• Bear call spread- Buy the higher strike call and sell the lowerstrike call with the same expiration month. The higher strike callis purchased as a hedge

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• Bull put spread- Sell the higher strike put and buy the lowerstrike put with the same expiration month as a hedge

Credit spreads

• Why use credit spreads? Typically an investor would like earnmoney by selling options, but does not want the unlimited risk ofselling naked options

• The use of spreads allows for a pre-defined risk

• Unique tradeoffs are created by buying one option and sellinganother option as a hedge

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• Hopefully the spread will narrow after it is sold and the investorcan earn a profit

• The ultimate goal is to earn the maximum profit for the creditspread which can earned at the lower strike call or the higherstrike put at expiration

Credit spreads

• Credit spreads can be used by investors looking toreduce their risk of the option sold by buying a higherstrike call (or a lower strike put) as a hedge

• A full understanding of the strategy is very important

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• Most importantly the credit spreads strategy shouldcomplement your overall market forecast

Complimenting your forecast

• If an investor is bullish on BPX- Credit bull putspreads may be the preferred debit spread strategy

• If an investor is bearish BPX- Credit bear call spreadsmay be the preferred debit spread strategy

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• Remember BPX is calculated as follows:– USD/GBP *100

– If the USD is rallying, BPX will be increasing

– If the USD is sliding, BPX will be falling

Risk and reward of credit spreads

• The maximum profit can be earned at the strike price sold atexpiration or lower for credit call or higher for credit put spreads

• Maximum profit for a credit spread is the credit earned

• The maximum loss for a credit spread can be calculated asfollows: the difference between the strike price less anypremium received for the spread is the credit spread seller’s

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premium received for the spread is the credit spread seller’smaximum loss

• The maximum profit can only be earned if the underlyinginstrument closes at or above the higher strike sold at expiration(puts) or at or below the lower strike price sold at expiration(calls)

Debit or credit spreads which is better?

• Contrary to what many investors may believe, there isno inherent economic advantage in selecting creditspreads relative to debit spreads

• The risk and reward of each strategy must beweighed, each investor can decide based on their

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weighed, each investor can decide based on theirown goals and their own risk tolerances

Selection of strikes and months

• The selection of strike prices and months should bebased on the investor’s forecasts

• The options market pricing is based on risk andreward scenarios; out-of-the-money (OTM) spreadswill be quoted at lower prices with a higher probabilityfor remaining out-of-the-money compared to at-themoney (ATM) spreads that will be quoted at higher

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money (ATM) spreads that will be quoted at higherquotations but with a greater chance of expiring in-the-money

• In-the-money (ITM) spreads cost the most in nominalterms, but have the highest probability of remaining inthe money at expiration

Selection of strikes and months

• Risk and reward must always be considered prior toentering any options transaction

• The selection of timing should be based on eachinvestor’s forecasts

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• OTM option spreads with less time will tend to bequoted at lower prices compared to OTM spreads withmore time

ITM, ATM, OTM which is best for buyers?

• Each spread has its own risk reward characteristics

• ITM spreads have the highest nominal (given short timedurations) prices and highest probability of remaining in themoney

• ATM spreads have lower nominal prices relative to ITM and lessprobability of expiring in the money at expiration

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• OTM spreads have the lowest nominal prices of the three types,they also have the lowest probability of expiring in the money atexpiration

Lots of choices for spreads (16 volatility, asset 56.27)

54/56 call spread

56/58 call spread

58/60 call spread

ITM ATM OTM

7 week 36 delta

1.31

24 delta

0.80

16 delta

0.41

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12 week 20 delta

1.27

20 delta

0.83

16 delta

0.48

16 week 14 delta

1.21

15 delta

0.89

19 delta

0.61

The benefits of debit spreads

• Spreads in general move more moderately in pricethan the single legged strategies (this can be both anadvantage and disadvantage depending on theunderlying movement)

• Debit spreads can help mitigate both the time decay

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• Debit spreads can help mitigate both the time decayrisk and volatility risk

Risk and reward for debit spreads

• Understanding probability can help investors selectthe best spreads to buy based on their own financialgoals and their own risk tolerances

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Option spreads can be used in many markets

• Equity option spreads

• ETF option spreads

• Equity broad index option spreads

• Equity narrow based index option spreads

• Foreign exchange option spreads

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12 month changes in exchange rates

10/01/07 10/01/08 Change

CDD 99.23 106.27 7.09%

YUK 114.82 105.72 7.92%

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EUI 70.09 71.38 1.84%

BPX 48.84 56.48 15.64%

USD/GBP ISE symbol BPX

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Weekly chart USD/GBP BPX

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BPX

• Implied volatility for BPX

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Recent volatility in BPX

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Using ISE FX options you can implement your FX views

• Spread trading allows investors to create uniquepayoffs

• Spreads allow for the reduced time decay risk andvolatility risk

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• Just remember, one disadvantage is that you limityour upside due to selling an option against yourpurchased option

Leverage from spreads

• The leverage from spreads will come from thedistance from the exchange rate and the strike pricesselected in your spread

• Deep-in-the-money options will be most expensivewith the likelihood of success high

• At-the-money options will be less expensive with

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• At-the-money options will be less expensive withpotential for success moderate

• Far-out-of-the-money options will be cheapest innominal terms with the likelihood of success muchlower

BPX example 56.27 value

2 monthcall

3 monthcall

6 monthcall

2 monthput

3 monthput

6 monthput

52 4.51 4.72 5.32 0.11 0.21 0.46

54 2.84 3.09 3.80 0.40 0.57 0.90

56 1.53 1.82 2.59 1.09 1.29 1.65

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56 1.53 1.82 2.59 1.09 1.29 1.65

58 0.73 0.99 1.70 2.28 2.46 2.74

60 0.32 0.51 1.09 3.87 3.96 4.11

BPX debit or credit spreads, you choose

Call spreads 2 month 3 month 6 month

52/54 1.67 1.63 1.52

54/56 1.31 1.27 1.21

56/58 0.80 0.83 0.89

58/60 0.41 0.48 0.61

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Put spreads

2 month 3 month 6 month

52/54 0.29 0.36 0.44

54/56 0.69 0.72 0.75

56/58 1.19 1.17 1.09

58/60 1.59 1.50 1.37

2 month call risk reward tradeoffs

Debit callspread

Risk Reward Creditcallspread

Risk Reward

52/54 1.67 0.33 52/54 0.33 1.67

54/56 1.31 0.69 54/56 0.69 1.31

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54/56 1.31 0.69 54/56 0.69 1.31

56/58 0.80 1.20 56/58 1.20 0.80

58/60 0.41 1.59 58/60 1.59 0.41

3 month call risk/reward tradeoffs

Debit callspread

Risk Reward Creditcallspread

Risk Reward

52/54 1.63 0.37 52/54 0.37 1.63

54/56 1.27 0.73 54/56 0.73 1.27

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56/58 0.83 1.17 56/58 1.17 0.83

58/60 0.48 1.52 58/60 1.52 0.48

6 month call risk/reward tradeoffs

Debit callspread

Risk Reward Creditcallspread

Risk Reward

52/54 1.52 0.48 52/54 0.48 1.52

54/56 1.21 0.79 54/56 0.79 1.21

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56/58 0.89 1.11 56/58 1.11 0.89

58/60 0.61 1.39 58/60 1.39 0.61

What is the future for US dollar/British pound exchange rate?

• The symbol is BPX, it represents the USD/GPB *100

• The BPX rate used is 56.27

• During periods of a rising US dollar the value willincrease, during periods of US weakness the valuewill decrease

• If you are bullish you can buy calls, call spreads, sell

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• If you are bullish you can buy calls, call spreads, sellputs or put spreads

• If you are bearish you can buy puts, put spreads, sellcalls or call spreads

2 month put risk reward tradeoffs

Debit putspread

Risk Reward Debit putspread

Risk Reward

52/54 0.29 1.71 52/54 1.71 0.29

54/56 0.69 1.31 54/56 1.31 0.69

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56/58 1.19 0.81 56/58 0.81 1.19

58/60 1.59 0.41 58/60 0.41 1.59

3 month put risk reward tradeoffs

Debit putspread

Risk Reward Debit putspread

Risk Reward

52/54 0.36 1.64 52/54 1.64 0.36

54/56 0.72 1.28 54/56 1.28 0.72

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56/58 1.17 0.83 56/58 0.83 1.17

58/60 1.50 0.50 58/60 0.50 1.50

6 month put risk reward tradeoffs

Debit putspread

Risk Reward Debit putspread

Risk Reward

52/54 1.56 1.56 52/54 1.56 1.56

54/56 1.25 1.25 54/56 1.25 1.25

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56/58 0.91 0.91 56/58 0.91 0.91

58/60 0.63 0.63 58/60 0.63 0.63

Debit or credit spreads?

• There is no inherent advantage of trading debit spreads or creditspreads

• Investors must be pre-approved for spread trading

• Spread trading allows for more moderate trading results due tothe simultaneous selling of an option against the purchasedoption

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• Debit or credit spreads both work. Theoretically, there isn’t anyadvantage in one strategy or another

• Spreads allow investors to tailor the risk reward payoffs that aresuitable for them based on the strike prices bought and sold andthe resulting debit or credit amounts

Summary of trading debit spreads using ISE FX options

• ISE FX options allow you to implement your views onthe foreign exchange market

• ISE FX options are European style, hence theycannot be exercised early (an advantage for optionsellers)

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sellers)

• European style does not allow for early exercise, butinvestors can always close out their option positionson any trading day prior to expiration

Summary of trading debit spreads using ISE FX options

• Trading debit spreads allow for the mitigation of both volatility and thetarisks. Debit spreads have a limited pre-defined risk

• Trading credit spreads allow for a limited risk method of selling options

• The goal of buying debit call or put spreads is to the potential wideningof the original spread bought

• The goal of selling credit call or put spreads is the potential narrowing of

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• The goal of selling credit call or put spreads is the potential narrowing ofthe original spread sold

• A full understanding of the desired spread strategy is recommendedprior to entering any options transaction

• Most importantly the spread strategy should complement your overallmarket forecast

Commonly asked questions regarding ISE FX Options

• Do the “greeks” work? Yes, if an investor inputs the correct interest rate and dividend yield(US risk-free rate) option calculators will work and of course the volatility

• Can I get volatilities for the ISE FX pairs? Yes, Ivolatility.com has the data on their site

• How much do these options cost? Same as equity options, $1.50 options costs $150

• How does cash settlement work? If the exchange rate is above the strike price (calls) orbelow (puts) at expiry the options have intrinsic value. i.e. If an investor holds a 100 put andCDD closes at $97 the option is worth $3 and $300 is deposited into your account at expiry

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• How does the term “pips” relate to ISE FX Options. Roughly speaking 100 pips equals 1 ISEpoint

• What does dollar relative mean? The base currency is the US dollar, if the US dollarincreases relative to the foreign currency the value of the pair increases, if the dollardecreases the value of the pair decreases

For more ISE FX Options education

• www.ise.com/webinars

• www.ise.com/podcasts

• www.ise.com/fx

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Steve Meizinger

www.ise.com

www.ise.com/fxwww.ise.com/fx

Smeizinger@ise.com