Forex Investment and Currency Trading

Options are not a simple investment vehicle and the terminology can be confusing.

Options may be used for speculation—to make a profit—or as a hedge— to protect a position maintained in the normal course of one’s business, if you hedge a speculative spot FOREX position with options, it is considered a speculative hedge. It is only a true hedge if you are hedging a legitimate business transaction that entails currency risk.

For speculation, options may be used as either a trading instrument in and of themselves or as a money management tool paired with spot FOREX trading.

New traders are advised to become fully comfortable in the spot FOREX space before considering options. Because of the additional time value component, the matrix of possibilities and strategies can be enormously complex and mathematically heady.

The value of an option decays over time until it reaches zero. The decay is not always linear, nor is its path easily predictable.

In options time is not on your side. It is a constantly deteriorating (”decaying”) value. The price of the underlying currency must not just move in your favor to make money, it must move enough to compensate for the time decay.

An Options Primer

An option is the right to buy or sell the underlying currency at a specific price for a specified period of time. You may purchase an option or write an option. For speculative purposes, purchasing is most common.

Options and Exotics

The right to buy is a call. You have the right to call the position away from someone holding the spot equivalent.

The right to sell is a put. You have the right to put a spot position to someone.

You purchase a call if you believe the currency price is headed up. You purchase a put if you believe the currency price is headed down. An option is a contract between a buyer and a seller; the seller is termed the writer, the buyer is the purchaser. Let us examine the purchase side first.

Basic Options Terms
The strike price is the price at which the call or put may be exercised. It does not make sense to exercise a call or put (exchange it for a spot position) unless the call or put is in-the-money—trading above (call) or below (put) the strike price.

You may, of course, offset your option, buying it back (a put) or selling it (a call) before the expiration or even if it is not in-the-money. You have effectively transferred your contractual obligation to someone else.

The expiration is the time frame of the option. In stocks and commodities, these are normally set for months. An option is said to expire in September, for example, in FOREX the expiration dates are closer since very few traders hold positions for months at a time.

The premium is the cost of the option. With options you are paying for the time-value as well as the price values. The underlying value of the option falls as time approaches the expiration—unless the price value increases at a faster rate. Options pricing, because of these twin values, can be complex and unpredictable. You may be correct on the price direction and still lose money because of decaying time values.

The intrinsic value of an option is what it is worth if exercised at any given time. When an option is out-of-the-money its only intrinsic worth is time value.

A call is in-the-money if the spot price is above the strike price; out-of-the-money if below. A put is in-the-money if the spot price is below the strike price; out-of-the-money if above.

The price of an option, or premium, is determined primarily by strike and expiration vis-a-vis the price of the underlying currency. But there are other factors such as liquidity, speculative fervor, and volatility. For example, an out-of-the-money call is more valuable if the underlying currency is volatile; it has a better chance of going to in-the-money. Forecasting option prices—even knowing or inputting the price of the underlying currency—is far from an exact science. A small change in time value or price value may cause the op don price to change by an inordinate amount. The various price factors appear to interact in a nonlinear fashion. Mathematic whizzes will find a similarity to the famous n-body problem.

Traditionally, currency options have been of two types:

• American-style: This type of option may be exercised at any point up until expiration.
• European-style: This type of option may be exercised only at the time of expiration.

If you trade with options, consider only American-style.

The Pros and Cons of Options
Major pro: Buying options limits your exposure. The maximum you can lose is the value of the option; the price you paid for it.

Purchasing options as a speculative vehicle offers limited downside—you cannot lose more than the price you paid for the option—and unlimited upside, at least on a call. If you purchase a put, your profit is technically limited to the underlying currency going to zero.

Options and Exotics
 
The cost of the option may be less than the margin on the same spot position.

Major con: You pay for the time value of an option. In spot FOREX other than rollover charges (typically very small), you do not pay for time you hold a position.

Forecasting option pricing—even given the price of the underlying currency—is difficult.

If your option expires worthless, you lose your entire purchase price. This can occur from prices moving sideways and the time premium decaying to zero. If prices move sideways for the spot trader, he loses nothing and retains his margin funds. You may find prices of the currency moving in your favor but not fast enough to compensate for the time decay—a discouraging predicament most options traders have experienced more than once. If the time on your option expires and the option is “our-of- the -money,” its value is zero.

The Four Basic Options Strategies
Terminology note: Be careful not to associate “buying” with calls only. You may also buy or purchase a put.
1. Purchasing a call
2. Purchasing a put 
3. Writing a call
4. Writing a put

Purchasing and Writing Options
You may purchase either a call or a put, although it may sound strange to purchase the right to sell.

You may either purchase or write an option—either a call or a put. Remember, an option is a contract between a purchaser and a writer. An option writer collects the premium as income from the purchaser. The writer of a call must be ready to have his spot position called away or purchase a spot position if the buyer exercises his option. The writer of a put must be ready to purchase (or repurchase) the spot position from the buyer of the put.

If a writer holds a spot position when he enters an options contract, he is said to be a covered writer. If he does not hold a position, he is said to be uncovered or a naked writer.

Advanced Options Strategies
The mathematics of options is enormously complex. There are many high-level option strategies based on combinations of puts/calls, writing/purchasing, different strikes and expirations. They are not for the new trader!

Some of these have exotic names such as “condor” or “butterfly” derived from the graph of profit/loss calculations for the strategy.

The Retail FOREX Options Landscape
There is a substantial Over-the-Counter (OTC) FOREX options market—this has been around for many years. But it is only open to banks, institutions, and large corporations. Fortunately large broker-dealers are beginning to tap into this arena and offer it to their customers.

For listed currency options, the retail trader must look to either the PHLX (www.phlx.com) or the International Securities Exchange (www.ise.com). Both offer listed FX options in a limited number of markets. Selection and liquidity is currently low, but listed FOREX options have enormous retail potential.

Options for Trading

If you have concluded a currency is going up or down in price, you may buy a call or buy a put on the currency. Today only a few major pairs are offered, but the list is growing; a few brokers are dealing options on exotic currencies. You gain the advantage of limited risk but pay for that limited exposure much like an insurance policy; if you don’t use it, it is lost.

Unfortunately, that limited risk tends to lull inexperienced traders into a false sense of security. They don’t have to make a decision about getting out of a bad trade because of a margin call and are prone to let a losing trade ride until either the price of the currency is so far away and/or there is so little time value remaining that the option expires worthless.

Always keep in mind the basic options con position. You may see the currency price go in your favor but the time value decays at a faster rate. The net result is your option goes down in value.

Options for Money Management
Options for money management make a lot of sense but require significant study, experience, and discipline for the  strategy to work properly. There are three basic strategies for money management with options but dozens of permutations on them. Remember, no matter how sophisticated your strategy is, you still must be correct about the price movement of an option to make a profit. There’s no magic in the torturing of the numbers.

These strategies are all based on long the EUR/USD.

Strategy 1: Perhaps you entered a market with extremely high volatility; long the Euro, short the US Dollar (EUR/USD). You might purchase a put on the Euro. Once prices begin to move in your favor, you can raise your stop to a break-even point and sell the put. Of course, you’ve lost money on the put, but you have bought time to allow your position to stabilize in your favor, if the trade moves against you instead, the option will cover at least a large portion of your spot trade loss.

Strategy 2: Perhaps you have a long-term trade in mind and plan to hold the position over several days. A put helps anchor your position against the risks and vagrancies of a long-term hold. In FOREX the risks associated with long hold periods is substantial.

Strategy 3: In this scenario of a long-term hold, you could write a call against your position and collect income during the holding time from the purchaser of the call. You must calculate the value of the income versus the risk of having your spot position called away from you.

Exotics
Although the terminology is not consistent throughout the industry: A major is a pair consisting of currencies from the United States (USD), Great Britain (GBP), Japan (JPY), Europe (EUR), Australia (AUD), and Canada (CAD). A minor pair consists of one of these and an exotic. An exotic is a pair with two exotics. Exotics may also be called emerging, although there is not a strict one-to-one relationship between the two.

Exotics are illiquid—there is much less trading in them than in the majors or minors. The degree varies; the Polish Zloty is relativelyliquid while the Thai Baht is very illiquid . The lack of liquidity means that pip spreads are high and large orders may be difficult to execute. Risks are greater but so is profit potential.

Given a news event in an exotic country, prices may soar or dive, and exiting at any reasonable price may be difficult. Devaluations are uncommon, but when they do occur, overnight price changes of 20 percent or more can be either a disaster or a windfall.

Old-time traders will remember the devaluations of the Mexican Peso in the 1970s of 50 percent or more. Fortunes were made—and lost—literally overnight.

Trading Exotics
If you are interested in trading the exotics, buying call or put options may be an excellent idea. The disadvantages of options trading probably outweigh the risks involved in spec trading. Nonetheless, the new trader should first gain experience in the spot FOREX arena before attempting options, exotics, or both.

Be very mindful of liquidity in exotics. If you think liquidity in the AUS/USD is poor at 9:00 pm, wait until you see the Thai Baht spreads! There is also the potential instability on these counties, causing their currencies to move suddenly and sharply. Re-quoting and ballooning spreads could be an issue, even for small traders.