From the April 2014 issue of Futures Magazine • Subscribe!

Create value in a narrow range market

Question:

What options strategy would allow you earn profit from a range bound market?

Answer:

A time value call spread short the near-term and long the further out contract can create value in a narrow range market.

When deciding which foreign currency would be the best to trade options on, taking a look at their liquidity should be the major factor in your decision. The most liquid contract by far is the euro, which has an open interest of 300K. The open interest in the Japanese yen (NYBOT:EJM14) checks in at 150K, the British pound (CME:E6M14) at 130K and the Australian dollar (CME:A6M14) at 100K. Meanwhile, the Canadian dollar (CME:CDM14) is at 80K. 

We’re going to focus on the Australian dollar (AUD). Let’s take a look at its price level over the last five years, (see“Boomerang currency,” right). On Mar. 2, 2009 in the midst of the global, über-recession, the AUD was trading at 0.6433.That means that a $100,000 is equivalent to $64,330. Just seven months later on Oct. 4, 2009, AUD settled at 0.9036. After the global freeze in economic activity thawed out the world was demanding Australian commodities again. AUD backtracked to 0.8173 on May 31, 2010. AUD has been on a steady upward trend since then until the middle of 2013. On July 25, 2011, AUD was trading above par at 1.1000. On Apr. 8, 2013, AUD was still above par at 1.0549. On Jan. 19, 2014, AUD settled at 0.86940. By Mar. 4, AUD had risen to 0.89410.

The initial margin requirement for the Australian dollar is $2,035. The maintenance margin is $1,850 in  U.S. dollars. That means that if your initial position in one futures contract goes against you for at least $185 you need to add money to your account to bring it back to $2,035. So when you are long the June futures at 0.89410 and it opens the next day at 0.89110 you would need to wire $300 to your account or your clearing firm could liquidate your position. The initial margin works out to be 2.3%. That works out to be a greater than 40 :1 margin. That’s terrific when the position moves in your favor. It can be a painful process of throwing more money into your position when the opposite occurs. 

Looking at AUD’s price chart during the past five years there is obviously room for it to go down substantially. That is not likely to happen, however, unless there is another black swan event. For AUD to far exceed the value of  USD, the  USD would have to lose its status as the world’s reserve currency. 

Trading options on the AUD can remove the margin bogeyman from equation. We’ll look at a time value spread. This strategy works best in a period of congestion. It is the AUD May-April 90 call spread. The May options expire in 93 days and the April options expire in 65 days (as of March 6). The May 90 call is trading at 0.01310 ($1,310) and the April 90 call is trading at 0.01050 ($1,050). Both options derive their value from the June 2014 futures contract and are out of the money. That means that their premium consists entirely of time value. If they were in the money then their premium would consist of both time value and expiration value (or intrinsic value). 

The trade works out to be a debit of $260 for each time it is established. If the AUD stagnates over the next two months then the trade is a big winner. Whenever you short an option you want it to go out worthless at expiration. Whenever you establish a long position in a call option you want the futures contract to go much higher. Obviously when your long position goes higher then your short position will go in the money.  That means that both options would lose all of their time value and be so deep in the money that their premiums would be identical and the value of the time spread would shrink to zero. What price, then, would be the perfect nexis for this spread? That would be 90. At 90 the expiring April option would go out worthless and you collect $1,050. At 0.6433 the April option would go out worthless but your May option would have lost all but a nominal amount of value even though it has another five weeks of life. So the optimal price point is when the short call is still worthless and the long call is at its maximum value given that requirement. The closer the spread is to 90, whether it happens to be above or below 90, the better.

Dan Keegan is an instructor with the Chicago School of Trading. Reach him at dan@thechicagoschooloftrading.com. 

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