From the April 01, 2011 issue of Futures Magazine • Subscribe!

Trading a quiet forex market likely to breakout

Question: How do you trade a quiet market likely to breakout?

Answer: Upside/downside ratio spreads

Before World War I, most national currencies featured convertibility to gold. At times, this could act as a drag on the economy. If an economy became vastly more productive and the gold convertibility feature prevented commensurate monetary growth, then economic growth would be stunted or even reversed. For all of its flaws, the gold standard did prevent runaway inflation of the sort that occurred in Germany under the Weimar Republic. That inflation ushered in the rule of Adolf Hitler. Great Britain abandoned the gold standard in 1931, and the United States followed suit in 1933 because of its severe economic contraction.

Toward the end of World War II in July of 1944, all 44 of the allied nations gathered in Bretton Woods, N.H. to hammer out a new international monetary system. Each currency’s value was tied to a specific amount of gold. The U.S. dollar was pegged at the rate of $35 for one ounce of gold. Foreign governments could sell their gold to the United States and receive U.S. dollars in exchange for the amount of gold that was sold. In August of 1971 the Nixon administration removed the United States from the gold standard. This action effectively ended the Bretton Woods System and launched the world economy into a system of floating exchange rates.

Less than a year later in May 1972, the Chicago Mercantile Exchange (CME) launched the trading of listed currency futures. The seven major currencies traded were the Swiss Franc, German mark, British pound, Japanese yen, Australian dollar, Canadian dollar and the Mexican peso. The Euro, which is dominated by Germany, has since replaced the German mark. In the early 1980’s trading in options on futures began on the CME.

The euro contract’s volatility skew is generally flat. It currently has a slightly greater amount of time value embedded in the option premium to the downside vs. the upside. Since time value will come to life with a downside move, let’s take a look at the euro 1340-1385 2 x 1 put spread. That means two puts will be purchased at the 1340 strike for 0.0135 ($3,375) against the sale of one put at the 1385 strike for 0.0288 ($3,600). If the euro closes above the 1385 strike, then the small profit of $225 will be retained. If it breaks to the downside in a reasonably short period of time, then the spread will be a winner. There are twice as many long puts as there are short ones, so time value will be accelerating to the downside. If the trader makes no adjustments and the euro goes down to 1340 at expiration, then there would be a loss of $5,625 for each of the spreads. The breakeven point in the spread would be at 1295.

Another spread that could be traded with a view to the upside would be the euro 1385/1430 call spread. If one 1385 call is purchased at 0.03070 ($3,837.50) and two 1430 calls are sold for 0.0135 ($3,375), the maximum loss on a downside move would be $500.50. Since the trader is net short calls there are potentially unlimited losses to the upside. That, however, is a strictly theoretical risk. As the futures contract rose in price the price level for the time value embedded in the call option would decline slightly. The trader could turn it into a butterfly by purchasing a 1475 call. This would completely define the risk involved. The trader also could buy in some of the short side if the trade was put on more than 1 X 2. If the spread was put on 5 X 10, for instance, the trader could purchase a couple of futures contracts, thereby converting the short calls into short puts. Only a big gap opening to the upside would pose a real danger to the trader.

Let’s take a look at what would happen if both spreads were put on at the same time. If the market stood still, there would be a minor loss. If the euro went up slowly or down quickly, then the cash register would be ringing. If it went down slowly, it would probably be the worst outcome. The important thing to remember is that the initial options position that is established is not as important as the adjustments that are made along the way.

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