One of the great benefits of forex options trading is the ability to play various scenarios at one time. A properly constructed options trade allows time to be right, usually in either direction. This situation has emerged from the uncertainty facing the European Union regarding the economic chaos in Greece and the general anemic economic recovery in Europe. In recent weeks, the euro has been suffering as a result of speculation of a downgrade of Greece’s sovereign bonds and its long-term credit rating. There even has been chatter about the end of the euro as a currency. This bear sentiment wave has taken the EUR/USD pair down 1,126 pips from the high on Jan. 13 of 1.4574 to a low of 1.3448 on Feb. 25. The ranges in the EUR/USD are truly spectacular, with over 700 pips monthly.
“Reversing again” shows a monthly EUR/USD chart illustrating the huge ranges over the last few years. Importantly, the EUR/USD is approaching the 61.8% Fibonacci retracement level of the October 2008 low to November 2009 high. This type of price movement is perfect for a three-month option play. We can play either direction.
A play on further Eurozone sovereign debt problems is justified. Spain also may be a downgrade target, German unemployment is increasing and a consensus is emerging that the European Central Bank will not raise interest rates until December 2010. Adding to the bearish view on the euro is the Feb. 24 Commitment of Traders Report, which showed an increase in euro futures short positions to 71,623 contracts from the 59,422 contracts the week before.
Additionally, the European Commission recently stated: “The economy is likely to expand just 0.7% in 2010.” Also, the Eurozone Economic Sentiment Survey shows a flattening of optimism. Sentiment indicators are leading indicators and the latest Eurozone survey is a bad omen for the Eurozone economy.
But there is another scenario. EUR/USD bulls could argue that the panic regarding the credit rating of Greece already is technically embedded in the price. It is overdone, and the currency pair is near a key support area at the 61.8% Fibonacci level. Any good news can cause a sharp rally. This bull perspective anticipates that there will be a rescue for the Greeks. If the U.S. recovery remains weak, and the Federal Reserve keeps expectations of low rates, we have dollar weakness playing into relative euro strength. Having established a bear and bull scenario, let’s explore both scenarios and structure a trade that can be put on.
When you feel a market is poised for a significant move but are not sure what direction the breakout will occur, options become a good tool.
If you are bearish, you can buy an at-the-money (ATM) June euro 1.36 put and sell the 130 put for $230 (based on ISE spot options prices as of March 1). The 130 put reduces your profit potential but offsets some of the cost of the ATM put. It creates a potential profit of $397, a nearly 2-1 risk/reward profile.
If you are bullish, you can buy the ATM 136 call and sell the 145 call for $301. As with the short strategy, the 145 call reduces the profit potential but also reduces the cost of the ATM option. And the trade provides a similar 2-1 risk/reward profile.
This position plays a EUR/USD bounce back to 1.45. It also is a good idea to check on option sentiment. An indicator to detect sentiment is the ratio of the premium of the call to the premium of the put. If the market is neutral it should be the same. If we look at a EUR/USD March 10 expiration for a call and a put, we can see where current sentiment is leaning. It is 18% costlier to go long the EUR/USD than short.
The risk profile of both scenarios provides a reward/risk ratio of nearly 2-1. Both are valid plays on the present uncertainty in the EUR/USD. In fact, both can be placed at the same time because we are not predicting which direction will happen first. A June expiration allows the trader room.
A trader simply could get long or short a spot or futures contract, but that would not prevent a trader from being whipsawed in case of a sharp reversal, which has been the norm in these markets.
The potential exists for both call and put spreads to work for the trader because swings over a three month period can provide opportunity for profits in the spreads at different times.
Abe Cofnas is the author of “The Forex Trading Course” and “The Forex Options Trading Course” (Wiley). Reach him at firstname.lastname@example.org