As with all trading, often the simplest fx trading strategy is the best fx trading strategy. Easy to understand and easy to manage. You know what to expect and you know where the risk lies. You know your upside, your downside, entry and exit points. What's not to like about simple trading strategies?
Well, sometimes simple just isn't enough. In fact, when you really analyse how you feel about an fx market, you will often find that your opinion is not easy to translate into an obvious, simple trade. Maybe you are bullish on currency X versus currency Y? That's a simple enough view and easy to gain exposure to by going long X versus Y. But when you try to understand your view more clearly, a different picture can emerge. Are you bullish right now or only in the medium or longer term? Maybe you expect a move to the upside in the short term, but think that move is capped in the medium term at a certain major resistance point? And what about the situations where you don't have a strong directional view about a currency pair, but you do have a view about the general amount of movement that can be expected? For example, maybe you are fundamentally neither bullish nor bearish on the euro in the medium term (you admit, you just don't know!), but you may feel strongly that a large move either way is right around the corner.
Extending the fx trading opportunities with options
Having a view that is more precise than just 'bullish' or 'bearish' is great, because the market rewards us more generously, the more accurate our prediction and the more precisely we have constructed our portfolio to profit from specific outcomes. But, this is only really true if you can establish a trading position that nicely mirrors your well-defined opinion. When we only trade the spot market, we limit ourselves to fairly one-dimensional trades. This is a missed opportunity. What we need are more trading possibilities and more trading choices. We literally need more options!
Trading options has often been over-looked by fx traders in the past for various reasons. The historical absence of exchange-listed fx options left a legacy where fx traders simply had not had exposure to options. Fortunately that is now changing and the facility for fx option trading via retail option brokers is becoming a reality. And the opportunities to enhance p&l and improve risk management for fx traders are really worth exploring.
Financial options give their owners the right, but not the obligation to trade something (say an fx pairing or a currency ETF etc.) at a certain price, in a certain quantity, by or on a certain date. That simple enough definition results in an incredibly powerful financial instrument that can dramatically broaden a trader's horizons when properly understood. Without going too far into the mechanics of options, let's give some idea of the possibilities they open up for the fx trader. Try to imagine how you would create a trade position that stands to profit from these views, just using the fx spot, ETF or futures market alone.
- You expect the market to remain tightly range-bound between two levels over the next 30 days, but to then move aggressively out of the range in the following 30 days.
- Your view of an fx pairing is bullish. You are currently long the pairing, but would like to receive a premium each in month in return for capping your possible profit for the month at a certain %age level.
- With respect to a certain fx pairing, you are neither especially bullish nor bearish. But you feel that if there is a move, it will be sharp and to the upside.
- You want to maintain a core long position in an fx pair. You have concerns about a move to the downside but you strongly think the market can only fall so far because of a support level. You would like to buy protection, but at minimal cost.
All of these situations, and hundreds others besides of even greater complexity, can be dealt with efficiently using options strategies. An option strategy is simply a combination of simple call and put options. By combining options of varying strikes and expirations correctly you can create profit and loss profiles that accurately represent your actual beliefs about the fx market. You can create cost-effective hedges for your existing portfolio. Or you can use options to create an income stream for your portfolio. The possibilities here are limitless.
Options are powerful financial instruments which can cut both ways. When harnassed correctly, options can allow you trade fx in several new dimensions. You can trade fx volatility as well as pure fx direction. You can profit from options even when you don't have a strong directional bias; after all, that is still an opinion and options allow you to match up your view more precisely with your actual portfolio. But it cannot be stressed enough that you need to make sure you understand how these tools operate and how they react under different conditions. If you want to include option trading in your armoury (as every serious trader should), it is vital to train yourself accordingly. Take your time and do your research. Practise option trading either via a paper trading options account or using an options market simulator. Learning the basic definitions and theory of options is surprisingly easy with dedication, but learning to trade options effectively, like any trading skill, takes time, patience and practice.
How to make options trading part of your fx trading skillset
A lot of option 'theory' is non-asset specific. In other words, any good 'Introduction to Options Trading' -style book or online resource will help. Once you have the basics covered, there is no substitute for practising option trading either via a paper broker account or, even better, using a good simulator that can teach you as you use it. Focus in particular on understanding the risks that are unique to options; for fx traders this can, naturally, be something of a blind spot. So pay particular attention to this. With the basics covered and with plenty of practise trading under your belt, it will be worthwhile to learn about the specifics of option trading for fx. There are now several good blogs dedicated to fx options and volatility trading. These are great resources which will also give you ideas about trades you might be interested in learning to incorporate in your overall fx strategy.
The bottom line
- Option trading can greatly expand an fx trader's horizons, in terms of positioning, p&l and risk management opportunities.
- Options are powerful financial tools whose risks need to be fully understood before an fx trader considers their use.
- There are great online resources available to make learning to trade options as simple as possible.