The spot forex market is a mixed chemistry of price action reflecting global interest rates levels and directions in and between countries. The forces that cause changes in the value of a currency are real but hard to quantify. The challenge posed to the trader is to integrate that “big picture” with current movements and find a trade with an edge. This is difficult as intraday movements produce a lot of noise that distracts the trader from seeing the long-term perspective. To meet this challenge other trading instruments are needed. A very effective solution is through forex options.
Today it is inconceivable to envision trading equities without a corresponding option market. The availability of a call or put on an underlying equity allows investors and traders to easily play either side of the market, hedge risk or maintain opportunity while reducing exposure.
Soon, it also will be inconceivable to trade spot forex without options, and the availability of option trading on forex is increasing. While traders have been able to trade currency options in the futures market, those options are really on the underlying futures contract and not directly on the spot market. Several forex brokers are offering options on spot (OTC options), but while trading these OTC options at forex brokers allow a trader 24-hour access, they are still not readily available on most platforms. The good news is that traders can trade options on spot forex through their equity accounts. If you can trade Google, you can trade forex options in the same account. This is truly a revolution in forex trading. The International Securities Exchange (ISE) and the Philadelphia Stock Exchange (PHLX) offer options on the spot currency pairs, and are expanding the pairs traded (see “FX option fact box,” below).
Tapping into the power and opportunity of forex options requires an understanding of the fundamentals. Consider the Canadian dollar. The Canadian economy has been booming as it has supplied the resources to fuel the current era of global growth. The loonie (Canadian dollar) has been a proxy for an oil play. If crude oil continues to go higher, the Canadian dollar will benefit, possibly reaching parity against the U.S. dollar. But for the retail forex trader, playing a move to parity through a spot trade is risky. The weekly range of the Canadian dollar is often more than 200 pips and other pairs are even higher, making long-term trades beyond the tolerance of the average spot trader. And while most analysts say crude oil will head higher, it certainly won’t be a smooth ride up. The forex trader may call the right move but will be stopped out before realizing a profit. This is where options come to the rescue.
Consider buying a March ’08 1.00 put. The trade has seven months to move to 1.00 and risk is limited to the premium paid. While this is far out-of-the money and therefore has a low Delta, a lot can happen in seven months. The loonie doesn’t have to get to parity for this option to make money; a strong move towards 1.00 could ignite volatility and increase the premium. An alternative option play is a put spread. With the loonie trading at 1.0500, buy the March ’08 1.025 put (premium @ 1.50) and sell the March ’08 1.00 put (premium of .75). If the loonie goes to parity or below by March expiration you earn $2,500 and your risk is limited to the premium paid, $750, plus commissions. This put spread (also known as a debit bear spread) allows the short U.S. dollar position more time to work and can profit on a smaller move.
Options also offer great opportunity in the yen. A trader can count on volatility in the yen and as long as there are huge differentials in interest rates between Japan and other countries, the carry trade will remain a force for weakening the yen. These conditions add up to opportunity. Spreads betting on a weakening or strengthening of the yen can be placed with a defined reward to risk ratio of better than 2 to 1.
Currencies have been at multi-decade extremes, creating opportunities for big moves, and options offer a safer way to capture those moves. Options allow traders to hold positions longer and define their risk. For the equity trader it offers the chance to achieve true inter-market trading. You can use currency options to hedge an equity portfolio against a dollar decline. For the new forex trader, it provides tools for risk management, reducing roundturns and avoiding margin calls. For all levels of experience, forex options enable traders to participate in the “big picture” with known and predetermined risks. As with all instruments, close attention has to be paid to risk management. But there is no doubt that with proper training forex options can become a key factor in trading to win.
Abe Cofnas is president of Learn4x.com and author of the forthcoming book The Forex Trading Course: A Self-Study Guide to Becoming a Successful Currency Trader (Wiley Trading). Email: Learn4x@earthlink.net.