Over the last 15 years that I have been trading, I have made efforts to fully understand multiple asset classes as I believe this is the best way for anyone to ensure maximum diversity, minimum risk and, of course, better profits across their investment portfolio. While I have always been very active in FX trading, it has always been options trading which sparked the most interest for me due to its multiple layers of complexity and strategy. With so many contracts, expiry dates and a whole host of strategies ranging from iron condors and strangles to vertical spreads, options are truly unique and allow us to make money from markets moving up, down and sideways, too. They can be used for position protection and stop losses as well, with the ability to also take in high probability profits from premiums when the odds are stacked in our favor. The question is, how can they be used in Forex?
When you trade an options contract, you never actually own the stock, currency or underlying asset but instead you are buying the right to own the underlying at a later time and date. If the underlying asset on which the option is held goes up in value and the trader has a contract saying that they can own it at a much lower price, then this would provide a great profit for the owner of the option contract. The only thing that the trader has to do first, is to pay a premium to actually own the option contract in the first place. Simplified, it is much like paying a premium for car insurance. When the term of the insurance runs out, you have to pay another premium for more coverage, but if you have an accident and need to make a claim on your insurance policy, then the contract really becomes worth something of value to you. Options are no different.
To make the most of options though, I would suggest a solid understanding of market direction analysis and risk management before anything else. If you are already working with a consistent trade plan which allows you to find solid objective buying and selling opportunities, along with well written rules for protecting your trading capital in the event that you are wrong, then options are pretty much like trading anything else.
When it comes down to the actual trading itself, in options we only have two specific forms of contracts, which are as follows:
The Call Option: Which gives the buyer the right to buy an underlying asset at a pre-agreed price and the seller the obligation to sell an underlying asset at a pre-agreed price, all within a limited period of time.
The Put Option: Which gives the buyer the right to sell an underlying asset at a pre-agreed price and the Seller the obligation to buy an underlying asset at a pre-agreed price, all within a limited period of time.
The big choice comes in options when the trader has to decide when they wish to be a buyer or a seller of the call or the put option. Call options make money when the underlying goes up in value, whereas Put options make money when the underlying goes down in value. There are other aspects like time and volatility which also have an impact on the premiums of options as well, but we will touch on that in a while.
For now, let’s look at when an option could be used. Take the below chart of EURUSD:
Buying Call Options
Above, we can see a daily chart of EURUSD hitting a level of Supply at 1.2402 and then dropping down to a level of Demand around 1.1882 where we could expect a rally in prices. Now, while it may be a good time to buy a Call option here, (because they go up in value if the asset goes up in value), the problem is that buying an option on the EURUSD pair is not a safe thing to do because options on FX Spot are not traded through a regulated exchange, meaning the prices are not transparent, volumes can be low and the dealers will define the spread. I would never recommend anyone trade Spot FX options for this very reason. However, there is an alternative which can be found in the form of an ETF called the FXE:
The FXE is traded just like a stock because it is an Exchange Traded Fund, which traders can buy into and which tracks the price of the EURUSD currency pair. This ETF is traded through the fully regulated stock exchanges. You can see that while it gaps most days, it tracks the price of the EURUSD and forms Supply and Demand levels at the very same time, offering us another way to effectively trade the EURUSD. Because it is an ETF, it therefore has liquid options available to trade on it, all of which are fully regulated by the Chicago Board of Options Exchange (CBOE). This is a much safer method to trade options on currency because it is an open market with regulation and volume, unlike if you tried to trade an option on EURUSD via an independent broker. If you did this, you would be trading directly against the broker and who wants that?
Looking at the same chart, let’s apply the third dimension of options to the picture, namely volatility, which is measured on the lower part of the chart with historic volatility in blue and implied volatility in red. These readings do not provide us with a directional signal but give us a better picture of the market forces, thus allowing us to craft a specific strategy which supports not only the directional potential of the FXE but also the volatility potential as well.
Think about this for a second: if you knew that a market had a very good chance of moving higher or lower in a very short space of time, do you think there would be people out there who would want to protect themselves against this? They would need an insurance policy; and with options, when the insurance premiums are high, we can sell those policies just like an insurance company does every day. More on this in my next article.
Trading currencies through options opens up a whole new dimension to trading for the disciplined market speculator who has a good idea of how to time the market. While there are limited opportunities to trade options on FX, they are there if you know where to look. Join me next time as I continue this introductory guide to the world of FX options and how to generate a return when the currency market is in a standstill, allowing us to get paid from knowing where the market is unlikely to go.
Take care and be well,