A lower dollar reflects the forces that drive the world economy. The current mix of nearly $100 crude oil and $800 gold are examples of these forces. A year from now we do not know what the mix will be, but we know trading opportunities occur when prices probe key points of support and resistance, so identifying these levels are key to determining the direction of the dollar in 2008.
Let’s first admit that many of the factors contributing to the current dollar weakness are unpredictable. Geopolitical concerns are always a wild card and the policy actions of world central banks can be described as a juggling act in the dark. However there are two innovative tools traders can use. The first is the Trade Weighted Index (TWI) and the second is Exotic Option premium prices.
We view the dollar mainly in terms of the dollar index (USDX) traded at ICE US (the former New York Board of Trade), but a broader look at the dollar is gained by tracking the TWI. A trade weighted index is a common method for countries and central banks to measure the strength of its currency. But the measure is against a basket of currencies weighted by the contributions of the countries to total trade. We can infer that a trend in a TWI reflects global fundamentals of trade much better than other indexes. The USDX chart shows a much more severe downtrend than the U.S. TWI. This is because the USDX over weights the euro.
The TWI not only confirms the dollar decline, but it also could spot a change (see: “leading the dollar”). A break of the TWI trendline near the Index number 70 could signal a changing trend. Remember the adage, “the trend is your friend, unless it is at an end.” If at any time in the coming months the TWI shows a dollar resurgence being able to probe and break its trendline, buying dollars would be justified.
Another innovative method for projecting the outer reaches of dollar support would be to use option premium prices to identify market expectations about what price levels are more probable than others. The forex option market is expanding rapidly and firms are beginning to offer platforms that provide professional tools for trading, as well as analyzing, market sentiment. One of them is the no-touch option. In the no-touch option the trader is anticipating that the currency pair will not touch a certain price point. There are two parts of the no-touch option. First is a selection of an expiration date, and second is the selection of a payout amount. The most that the trader risks in trading a no-touch is the amount paid for the option. But a trader doesn’t have to trade these options to obtain valuable insight into market valuations.
Let’s assume the trader’s point of view is that the EUR/USD will never get to 1.50 by May 5, 2008. The no-touch option premium will provide a clue to what the market is saying. The premiums charged for such an option increase as the EUR/USD’s price moves away from the present spot market. We can infer what the market “thinks” about the strength of resistance levels for the EUR/USD. We estimate that the premium for a 1.50 strike no-touch option would be $545 and the premium for a 1.51 strike would be $627. The market believes that the likelihood of the EUR/USD reaching 1.51 by May 5 is 39% lower than it reaching 1.50. If the market sentiment were that the EUR/USD would likely to higher levels, then the premium’s costs would drop. Remember that no-touch means that the trader will profit if the price is not hit. The more the house expects to lose, the greater the premium paid. An important variable is time. The probability of an option not touching a certain price is higher when it has less time to do it and there are fewer outside factors that can affect it.
While the trader can never be sure of how far a currency pair may go, once a certain level of support or resistance is anticipated, the trader looking at the no-touch options can at least quantify market sentiment about different support and resistance barriers. In the coming year traders will need all the tools they can get to gain an edge in these volatile times. Several firms (Oanda, Finotec, Saxobank) are offering access to exotic options such as no-touch. As forex options become more popular the availability of exotics are likely to increase.
Abe Cofnas is president of learn4x.com LLC and author of The Forex Trading Course: A Self-Study Guide To Becoming a Successful Currency Trader (Wiley Trading). E-mail: firstname.lastname@example.org.