Options Role In Forex Trading

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Options Role In Forex Trading

Forex (Currency) Author: Admin


At the Interbank level, options have been an integral part of the FOREX landscape for many years. It is estimated that options may comprise up to 20 percent of FOREX market share, a substantial portion for hedging purposes by banks and corporations.

A bank may be at risk on an international loan for a short time. Hedging with currency options can eliminate that risk. Hedging acts as an insurance policy. If the bank is at risk on the long side of the EUR/USD, it can take the opposite position in options. A corporation might do the same while awaiting payment on a large sale. Loss on the business-side transaction is compensated by a profit in the hedge. For retail currency traders, speculative options trading has been the domain of seedy boiler room operations until recently.

There are now three domains in which you may trade currency options:

  1. exchange trade listed currency options;
  2. you can spread-bet currency options at some of the spread betting operations mentioned in Selecting a FOREX Broker Guide; and
  3. several reputable retail broker-dealers now offer FOREX options on over a dozen or more pairs and with a wide variety of features.

I now recommend traders who wish to work with currency options use a retail FOREX broker. The advantages and convenience of being able to trade spot FOREX and the corresponding FOREX options under one roof is substantial.

Spot FOREX options may be used either as a substitute for spot trading or they may be used as a money management tool with spot trading.

Exotics, currency pairs with the USD or EUR, and a small or exotic country’s currency provide exceptional opportunities along with higher risks than the majors or top-tier crosses. They offer variety, have trading personalities all their own, and may be especially attractive if you have some knowledge or insight about the exotic country other traders do not.

For U.S. traders, exotics have lost much of their appeal. New regulations limit leverage on them to 10:1.

What Are Options

Options are not a simple investment vehicle and the terminology can be confusing.

Options can be used for speculation — to make a profit — or as a hedge — to protect a position maintained in the normal course of one’s business. If you hedge a speculative spot FOREX position with options, it is considered a speculative hedge. It is only a true hedge if you are protecting a legitimate business transaction involving currency risk.

For speculation, options can be used as either a trading instrument or as a money management tool paired with spot FOREX trading.

I strongly advise new traders to become fully comfortable in the spot FOREX space before considering options. Because of the additional time value component, the matrix of possibilities and strategies can be enormously complex and mathematically heady.

In options, time is not on your side. It is a constantly deteriorating (decaying) value. The price of the underlying currency must not just move in your favor to make money; it must move enough to compensate for the time decay. Every options trader has experienced this: the call is due to expire soon and suddenly the underlying vehicle (a stock, a commodity, a currency pair) begins to move up, sometimes dramatically. But the option is decaying even faster than the underlying vehicle is going up. The result: the price of the option continues to go down. In the meantime, the buyer of the spot pair has made a tidy profit.

A Primer On Options

An option is the right to buy or sell the underlying currency at a specific price for a specified period of time. You can purchase an option or write an option. For speculative purposes, purchasing is most common.

The right to buy is a call. You have the right to call the position away from someone holding the spot equivalent.

The right to sell is a put. You have the right to put a spot position to someone.

You purchase a call if you believe the currency price is headed up. You purchase a put if you believe the currency price is headed down. An option is a contract between a buyer and a seller; the seller is termed the writer, the buyer is the purchaser. The writer captures the cost the purchaser has paid for the option. Writing is generally a means to gain income off a long-term position you are willing to close if the option is called away from you or put to you.

Basic Options Terms

The strike price is the price at which the call or put may be exercised. It does not make sense to exercise a call or put (exchange it for a spot position) unless the call or put is in the money — trading above (call) or below (put) the strike price.

You may, of course, offset your option, buying it back (a put) or selling it (a call) before the expiration even if it is not in the money. You have effectively transferred your contractual obligation to someone else. You might purchase a call out of the money and sell it out of the money and still profit thereby.

The expiration is the time frame of the option. In stocks and commodities, these are normally set for months. An option is said to expire in September, for example. In FOREX, the expiration dates are closer since very few traders hold positions for months at a time.

The premium is the cost of the option. With options, you are paying for the time value as well as the price values. The underlying value of the option falls as time approaches the expiration — unless the price value increases at a faster rate. Options pricing, because of these twin values, can be complex and unpredictable. You can be correct on the price direction and still lose money because of decaying time values.

The intrinsic value of an option is what it is worth if exercised at any given time. When an option is out-of-the-money, its only intrinsic worth is time value.

A call is in the money if the spot price is above the strike price and out of the money if below. A put is in the money if the spot price is below the strike price and out of the money if above.

The price of an option, or premium, is determined primarily by strike and expiration vis-à-vis the current price of the underlying currency. But there are other factors, such as liquidity, speculative fervor, and volatility. For example, an out-of-the-money call is more valuable if the underlying currency is volatile; it has a better chance of going to in the money. Forecasting option prices — even knowing or inputting the price of the underlying currency — is far from an exact science. A small change in time value or price value may cause the option price to change by an inordinate amount. The various price factors appear to interact in a nonlinear fashion. Math whizzes will find a similarity to the famous n-body problem.

vanilla option is one with only the basic components of expiration date and strike price. An exotic option contains complicated features and complex payoffs that often are determined by outside factors. Exotic options are mathematically complex; going to the moon was easier than predicting exotic options in the author’s humble opinion.

Traditionally, currency options have been of two types:

  1. American style: This type of option may be exercised at any point up until expiration.
  2. European style: This type of option may be exercised only at the time of expiration.

If you trade with options, consider only American style, vanilla.

Options: Pros And Cons

Major pro: buying options limits your exposure. The maximum you can lose is the value of the option, the price you paid for it.

Purchasing options as a speculative vehicle offers limited downside — you cannot lose more than the price you paid for the option — and unlimited upside, at least on a call. If you purchase a put, your profit is technically limited to the underlying currency going to zero.

The cost of the option may be less than the margin on the same spot position.

Major con: you pay for the time value of an option. In spot FOREX, other than rollover charges (typically small), you do not pay for the time you hold a position.

Forecasting option pricing — even given the price of the underlying currency — is difficult.

If your option expires worthless, you lose your entire purchase price. This can occur from prices moving sideways and the time premium decaying to zero. If prices move sideways for the spot trader, he loses nothing and retains his margin funds. You may find prices of the currency moving in your favor but not fast enough to compensate for the time decay — a discouraging predicament most options traders have experienced more than once. If the time on your option expires and the option is out of the money, its value is zero.

The Four Basic Options Strategies

Terminology note: Be careful not to associate buying with calls only. You may also buy or purchase a put.

  1. Purchasing a call: Profit if prices go up.
  2. Purchasing a put: Profit if prices go down.
  3. Writing a call: Profit if the call buyer is incorrect.
  4. Writing a put: Profit if the put buyer is incorrect.

Purchase Or Write Options

You may purchase either a call or a put, although it may sound strange to purchase the right to sell.

You may either purchase or write an option — either a call or a put. Remember, an option is a contract between a purchaser and a writer. An option writer collects the premium as income from the purchaser. The writer of a call must be ready to have her spot position called away or purchase a spot position if the buyer exercises her option. The writer of a put must be ready to purchase (or repurchase) the spot position from the buyer of the put.

If a writer holds a spot position when he enters an options contract, he is said to be a covered writer. If he does not hold a position, he is said to be uncovered, or a naked writer.

Generally, an options purchaser does so for profit or protection. An options writer does so for income or protection.

High-Level Options Strategies Worth Considering

As I have mentioned, the mathematics of options is enormously complex. There are many high-level options strategies based on combinations of puts and calls, writing or purchasing, different strikes, and expirations. They are not for the new trader!

Some of these have exotic names, such as condor or butterfly, derived from the graph of profit-and-loss calculations for the strategy. I know, not much more impressive than the so-called Big Dipper constellation. But where would we be without imagination?

What Do Various Greek Letters Stand For In Options?

A number of Greek letters have found their way into options terminology: delta, gamma, rho, and theta.

  • Delta is a measure of the change in the price of the option resulting from a change in the price of the underlying currency pair.
  • Gamma is the change in delta.
  • Rho relates the options price to the prevailing interest rate.
  • Theta is the change over a fixed time with all other factors remaining unchanged.
  • Vega, neither Greek nor Chevrolet, relates options price to implied volatility. Enjoy!

Options Or Spot Forex?

If you have concluded that a currency is going up or down in price, you may buy a call or buy a put on the currency. The number of pairs offered to retail traders is growing quickly. Two or three years ago, only the majors were available; today, some brokers offer them on more than 40 pairs. You gain the advantage of limited risk but pay for that limited exposure. Much like an insurance policy, if you do not use it, it is lost.

Unfortunately, that limited risk tends to lull inexperienced traders into a false sense of security. They do not have to make a decision about getting out of a bad trade because of a margin call and are prone to letting a losing trade ride until either the price of the currency is so far away or there is so little time value remaining that the option expires worthless. As a young trader in 1973, I watched my five Ford options slide from 11/2 to zero over a two-week period. “Tomorrow will be a better day.” Tomorrow never came. Always keep in mind the basic options position. You may see the currency price go in your favor but the time value decays at a faster rate. The net result is that your option goes down in value.

Risk Management With Options

Options for money management make a lot of sense but require significant study, experience, and discipline for the strategy to work properly. There are three basic strategies for money management with options but dozens of permutations on them. Remember, no matter how sophisticated your strategy is, you still must be correct about the price movement of an option to make a profit. There is no magic in the torturing of the numbers, friend.

These four strategies are based on long the EUR/USD.

  • Strategy 1: Perhaps you entered a market with extremely high volatility; long the Euro, short the U.S. Dollar (EUR/USD) just before an important news announcement is due. You might purchase a put on the Euro. Once prices begin to move in your favor, you can raise your stop to a breakeven point and sell the put. Of course, you have lost money on the put, but you have bought time to allow your position to stabilize in your favor. If the trade moves against you instead, the option will cover at least a large portion of your spot trade loss.
  • Strategy 2: Perhaps you have a long-term trade in mind and plan to hold the position over several days. A put helps anchor your position against the risks and vagaries of a long-term hold. In FOREX, the risks associated with long hold periods are substantial.
  • Strategy 3: In this scenario of a long-term hold, you could write a call against your position and collect income during the holding time from the purchaser of the call. You must calculate the value of the income versus the risk of having your spot position called away from you.
  • Strategy 4: You find a great trade, but the stop-loss would be too far away for your trading profile or perhaps a new report is pending. You can sell the spot pair and simultaneously buy a call option. As soon as your primary trade (the spot pair) reaches a point at which you can place a break-even stop-loss, you cover (sell) the call option. You will lose some money on the option but if the pair performs according to your expectations, then being able to take the trade justifies the cost. See Figure below.

Options are relatively expensive. You might think a good strategy would be buying both a short-term call and a put before a big news announcement. If prices move dramatically, the profit on one will more than compensate for the loss on the other. Others have also considered the idea. Option prices spike before such events, making a profit unlikely, except for a quite extraordinary price move. There is no free lunch; sophisticated traders and researchers have almost certainly already studied or tried any strategy you may discover. Said another way — the markets are efficient.

Because of the complex matrix of possibilities, options have probably come under more mathematical scrutiny than any other investment vehicle.

What Does Exotics Mean In Trading?

Terminology is not consistent throughout the industry: a major is a pair consisting of currencies from the United States (USD), Great Britain (GBP), Japan (JPY), Europe (EUR), Australia (AUD), and Canada (CAD). An exotic is one of these (usually the USD or EUR) and one of the currencies shown in the table below. A pair comprised of two exotic currencies is called asking for trouble. Exotics may also be called emerging, although there is not a strict one-to-one relationship between the two.

Exotic Currencies

Czech RepublicKorunaCZK
MexicoMexican PesoMXN
South AfricaRandZAR
YugoslaviaNew DinarYUD

Exotics are illiquid — there is much less trading in them than in the majors or minors. The degree varies; the Polish Zloty is relatively liquid while the Thai Baht is very illiquid. The lack of liquidity means that pip spreads are high and large orders may be difficult to execute. Risks are greater, but so is profit potential.

Generally, the best fills are during the appropriate session relative to the exotic: European session for the Zloty, Asian session for the Baht. Fills are an issue for exotic traders and make short-term trading difficult because such costs must be figured into the equation. Fifteen pips on a 50-pip swing is too rich, but on an anticipated 200 pips, it may be livable.

Tip: Trading in the MXN, PLN, and TRY has increased considerably. Traded with the EUR or USD, there is enough liquidity and small enough trades to justify considering them if your trading method brings them to your attention.

The NFA has mandated that exotic currency pairs must be backed up with a minimum of 10 percent margin, yielding a maximum leverage of 10:1. Because of this limitation, many U.S. traders interested in exotics have moved their accounts to overseas broker-dealers to avoid this limitation. But this loophole is also closing rapidly.

Given a news event in an exotic country, prices may soar or dive, and exiting at any reasonable price may be difficult. Devaluations are uncommon, but when they do occur, overnight price changes of 20 percent or more can be either a disaster or a windfall.

Long-time traders will remember the devaluations of the Mexican Peso in the 1970s of 50 percent or more. Fortunes were made — and lost — literally overnight.

How To Trade Exotics

If you are interested in trading the exotics, buying call or put options may be an excellent idea. The advantages of options trading probably outweigh the risks involved in spot trading. Nonetheless, I believe that the new trader should first gain experience in the spot FOREX arena before attempting options, or exotics. GFT FOREX is a trailblazer in offering exotics to retail customers, but most other major brokers offer at least a few exotics. Notable is Gain Capital and SaxoBank. FXPro offers a large exotic palette for non-U.S. traders. Visit websites for a list of currencies traded by each broker-dealer. I must repeat: be mindful of liquidity in exotics. If you think liquidity in the EURCHF is poor at 5:00 p.m. Eastern Standard Time, wait until you see the Thai Baht spreads! There is also the potential instability of these countries, causing their currencies to move suddenly and sharply. Requoting and ballooning spreads could be an issue, even for small traders. If you use an electronic communications network (ECN) broker instead of a market maker to trade exotics, be doubly cautious. Remember, an ECN must find an order to match yours and does not act as a counterparty to your trades. If you place a market order to buy, prices will rise until a seller is found. Hopefully, a rug merchant will need change to sell a rug to Aunt Martha and bail you out. Begin trading exotics in mini-lots of 10,000 to get a feel for liquidity and other potential execution issues. Seek out broker-dealers who advertise exotics. Most brokers can get access to just about any currency pairs.

Is There An Opportunity For Options In FOREX?

Options, especially, have come into their own with retail traders — both as an investable vehicle in and of themselves and as a risk management tool for spot FOREX positions. Exotics, which were just getting a head of steam in the United States, were cut down by the new margin requirements instituted in 2010.

Options and exotics offer new possibilities for traders and open many doors to new and exciting trade opportunities. My advice: There is enough action in the major pairs and the top-tier minors and crosses in the spot market to satisfy most traders. Consider options as a money management tool more than as a substitute for spot FOREX. Trade options as speculative vehicles only after you have become experienced in the spot market of the major pairs and crosses. That said, currency option trading for speculative purposes is expected to continue to grow in the years ahead. The magnet of limited risk — whether rational or not — is appealing to many traders. As volume increases, also expect a rise in the interest of sophisticated option plays as opposed to the simple buying and selling of puts and calls. If brokers see a market for a certain exotic, they will offer it.

Exotics have real appeal to the experienced trader, in my opinion. While liquidity is poor and fills on trades can be miserable, the trends tend to be long. If you can get aboard, you might catch a nice long ride. When online retail FOREX first began in the 1990s, the markets were inefficient; classical chart patterns that have not really worked well in futures or stocks for decades played out like textbook examples for two or three years. Alas, more traders arrived, and with them, the liquidity and the efficiency and the easy pickings disappeared. There is a sense that because of the low interest — for now — in exotics, the markets are still relatively inefficient. This market inefficiency can make them subject to better profit potential than the majors, ceteris paribus. I see clean classical chart patterns, for example, frequently on the longer-term EUR/PLN (Euro Polish Zloty) charts. But be cognizant of the minimum margin requirement of 10 percent for U.S. FOREX traders. If you have the experience, time, and the inclination, spot FOREX exotics may well offer meaningful opportunities. Because of liquidity, spreads, and — in the United States — poor leverage — they are usually better long-term trade candidates. Specializing in an exotic can offer a basic course in fundamental analysis, at the very least. Adopt a Baht today.