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The differences between the forex spot and option trading perspectives generate different strategies and goals and also a differ- ent need for information. For example, the spot trader often seeks frequent small moves and focuses on intraday and intrahour charts, avoiding the need for constantly absorbing information on fundamentals and the big picture.
Forex option trading requires more experience evaluating broad market conditions and top-down analysis, while forex spot trading requires greater focus on trading itself with precision management of moment-to-moment trading. The presence of high leverage exists in both spot forex and options on forex trading. However, the main difference is that many of the forex option techniques explored in this book provide high leverage without the associated risks of margin calls.
This book is different from the option literature that is available—a great deal on the Internet—because it places the concepts of option trading in a strict forex environment with examples to guide the reader. The book is also designed to prepare the forex trader for new option variations and intermarket choices for shaping and putting on forex op- tions. Those individuals who are familiar with equity option or futures option trading will find the application of basic option principles to be straightforward.
But it should be clear that in the coming years forex trading is going to occur in many venues. The rise of exchange-traded funds ETFs provides a rich new source of data on forex option price action. The forex option trader will improve the odds of winning by tapping into more than one market for information. The ETFs will certainly become a tool for trad- ing. The futures markets are also improving their forex option product line. But this book is also de- signed to prepare the forex trader for these and even newer variations in forex options that are coming to the market.
Binary options allowing traders to play touch, no-touch, double-touch, and double-no-touch are becoming available worldwide and in the United States. These binary options will revolutionize the ability of people to trade forex with limited risk. For the serious forex trader, considering forex options and becoming skilled in forex options analysis is advisable because it is increasingly apparent that the world is, more than ever, interconnected.
Equity, commodity, and debt markets cannot be totally separated. They all tap into each other and generate a global liquidity market that fuels buying and selling. The forex market reflects the totality of market psychology versus the prospects of growth versus inflation. Our goal is to provide the reader access to the right information to make the most well-informed decision. The challenge of trading forex is among the most exciting of all the markets, and this book is designed to help the trader meet those challenges.
Acknowledgments T his book became a reality because of the contribution of many people. Foremost are my students in forex who enabled me to evolve a deeper understanding of forex trading and in particular the potential benefits of understanding forex option trading. In the writing of this book, superderivatives.
Their advanced analytics engine was made available to me for the purpose of writing this book and it offered a rare opportunity to present dimensions of analysis that is usually attributable to institutional research. Udi Sela deserves acknowledgement for provid- ing professional forex option trading insight and expertise to ensure that the strategies and tactics described had validity. My student and colleague Reynolds Lee deserves recognition for generating a great deal of the charting in the book.
His expertise in visual numerics is world-class. Lastly my wife, Paula, needs to be acknowledged for providing an environment con- ducive to the work required to complete the manuscript. He has been a leader in designing and deliv- ering forex training courses. He has conducted seminars in the United States, London, and Dubai as well as online training in all time zones.
Cofnas founded www. He has since developed forex coaching with ad- vanced performance analytics. He is head forex coach at secretsoftraders. Recently he founded fxdimensions. He has been in the financial service industry as an equity broker, futures, and forex trader since He currently lives in Longwood, Florida, with his wife, Paula, where he conducts research on artificial intelligence programs using cellular automata and enjoys digital photography.
He has a daughter, Paige, and a son, Paul. This includes a description of plain vanilla options and how option premiums are impacted by volatility. The simplest form of option trading is called plain vanilla. Plain vanilla options in all markets include calls and puts and are exactly the same as in forex trading. Purchasing an option means holding an op- tion. A trader purchases an option by paying a premium for it. Calls Once a trader has purchased gone long and is holding a call, he has the right but not the obligation to buy the underlying spot forex upon expiration.
The key concept is that a buyer of a call anticipates an upward move or is bullish. The trader selects a target called a strike price. If the price of the spot forex moves through and beyond the strike price, the position will be in profits. This is a generic example for any call. To be clear, the example as shown in Figures 1.
Actually, to be profitable if held to expiration, the spot position needs to be 79 pips beyond that, or 1. But the most that the trader would lose is the premium paid and any associated other fees source of the premium price example: www.
Puts Once a trader has purchased gone long and is holding a put, he has the right but not the obligation to buy the underlying spot forex upon expiration. What is important about purchasing an option is the element of risk control. Once an option is purchased and the premium is paid along with any other fees , this total cost is the maximum risk facing the trader. No matter what happens to the price action, the most the trader can lose is the cost of the premium paid.
The key concept is that a buyer of a put anticipates a downward move or is bearish. In Figures 1. The market price is at 1. The strike price selected is at 1. The expiration date is February The trader placing this put will pay in pip terms pips if trading a standard lot of , This means that the break-even point will be 1.
It is possible that the premium price could move up in value if volatility in the market increased and the GBPUSD fell quickly and early toward the strike point source of premium price exam- ples: www. The trader needs to always remember that time itself is important. The longer the time to expiration, the greater the risk that the strategy can go wrong and a new event will interfere and change the price direction. However, more time can allow the trade to work out and overcome periods where the price movements go against the trader.
Time is a double-edged sword for the forex option trader. Figure 1. Remember this is pips away from the spot price which is at 1. Compare the premium price of this put to the call that was at or pips away, which was at In other words, the market expected the move to be up be- cause the price of an option almost the same distance was much higher for the call. The trader purchases an option, but from whom?
In forex, the other side is the forex firm that makes the market and establishes the premium prices. In the future it might be- come direct matching between buyers and writer or options. The writer originates the option trade and is looking for a buyer.
The writer of a call is anticipating that the price of the underlying spot forex position will not get any higher than the strike price at expi- ration. The writer of the put is anticipating that the underlying spot price will not get any lower.
In the examples earlier, what if the trader wrote the call option? He would have received the premium minus the spread. The writer receives the premium from the buyer of the option. That is the most the writer will get! The risk is theoretically unlimited if the price of the option goes the other way. A visualization of the risks of writing a call or put is provided in Figures 1. At first, many traders who try writing these options tend to underesti- mate the risks.
The strike prices seem far away, and it appears that the risks for the price to move against the trader are very small. This is a dangerous assumption, par- ticularly in forex markets. Prices move hundreds of pips in hours on unexpected news. Therefore, in writing a call or put, the trader needs to make sure that the strike price gives room for larger-than-expected moves. In Figure 1. Spot price—the exact market value of the spot currency at the moment.
Option type—refers to whether the option is a call or put or other variety. Strike price—the price the trader selects as the barrier, which will determine if the trade becomes profitable. Valuation date—the date on which the valuation is valid. Expiration or maturity date—the date when the option expires and the owner of the option no longer has the rights to it.
An American-style option can be exercised before. With European-style op- tions, which are very common in forex, the trader is protected from being exercised against if the trade is not going his way. Days to expiration—the time until option rights expire. Notional amount—the amount that a unit of the option a lot is controlling i. Comparison of Option Premium Pricing among Forex Firms It is advisable that the forex option trader carefully review option premium pricing among the different firms offering it.
One of the reasons for this variation is the lack of many participants in the industry. In the Money, At the Money, and Out of the Money In placing an option trade, the center of attention for the forex trader is on where the spot forex price is. The spot price is called the at-the-money strike price. Options can also be deep in the money and deep out of the money. The term moneyness refers to this relationship of the option price to the at-the-money price.
The most likely option strategy for success is buying an in-the-money option position. This means that he will get the maximum movement of the option with the spot. Once a position is in the money, it moves on a basis with the spot. The advantage of an in-the-money option versus a spot position is that it will cost the trader only the premium and no other risk is associated with it.
The disadvantage is that the premium costs a lot more. The next type of trade relating to moneyness is the at-the-money option. This is when the option strike price is where the spot is. This kind of positioning allows the trader to be close to the action without paying as much as the in-the-money option.
ATM options move with the spot at 50 percent of the movement. This is called a delta factor and will be discussed in more detail shortly. The out-of-the-money option trade is the most popular trade. The hope of the forex trader is, of course, that the price will during the duration of the op- tion trade move toward the strike price or exceed it.
The option trader makes money by being right not only if the spot price actually moves to and beyond the strike price at expiration, but whether along the way it is expected to move in the direction of the price.
The objective is trying to use all the tools that are available to increase the probability of being right about the direction of the option trade about market expectations, and about its timing. Time value and the moneyness of an option have a direct relationship, which is shown in Figures 1.
Intrinsic Value versus Time Value The forex option trader is always undertaking a multidimensional bet. Affecting the re- sult is a combination of variables that have to come together in favor of the trader. Of critical importance is the time left to expiration and the risk changes in volatility. This interest rate effect is a small factor called rho. Generally, a lowering of interest rates will reduce the option price. The currency market takes in known as discounting all factors and reflects them in the option premium price.
This means it also takes in the psychological aspects of fear and greed in the market. Therefore, it would be a mistake for the forex trader to think that the premium price of an option is always fair. The reality is that there is great uncertainty regarding market directions But, ultimately, it is a balancing act between the trade that the trader has on and the time left for it to work.
The best term describing this is in- trinsic value versus time value. After an option trade is put on, the intrinsic value is the value of the option if it were to expire at that moment. If the option strike price has not yet been reached, the value is all time value.
Intrinsic value increases if the underlying price exceeds the option strike. Fair Value Often, the trader will see the term fair value applied to options. A good way to under- stand the meaning of fair value is to realize that the market would not tolerate for too long an option premium that is mispriced. Traders would spot this discrepancy and take advantage of it through arbitrage. Therefore, fair value is the price where any arbitrage would be impossible.
The market is always seeking a way to efficiently price an option. If pricing was ineffi- cient or unfair, the thousands of participants in trading the market would seek to find an advantage and be able to significantly profit from that advantage. These are called arbi- trage opportunities. A vast body of financial mathematics and expertise has developed to constantly improve the algorithms that generate a fair price of an option. The most famous of all of the mathematics of option pricing has been the Black-Scholes equation.
The Nobel Prize was awarded for developing the mathematics behind this equation. It forms the basis for the market to fairly price an option because the equation showed what a fair value would be for a premium on an option. But the equation assumes con- stant volatility.
Black-Sholes was not developed for forex markets where there is no constant volatility. The world of forex options is not a Black-Scholes world, and for the average trader, this means he or she must be even more cognizant of the probability that during the option trade period, changes will occur in the market environment that can- not be fairly reflected in the premium prices.
The forex option trader has a paramount need during the option trade to allow enough time to be right but not enough time for too many changes in the real-world environment. More important for the forex trader is monitoring and understanding the Greeks. These are Greek terms that indicate quantifiable parameters that affect the price of the option. The average retail forex trader does not have to pay too close attention to all of the Greeks.
However, they are very important to large hedges and institutional traders who take on big positions. For these traders a small factor in one of the Greeks can make a difference. Among the Greeks, delta is the most important in developing trading strategies. Later on, we will use them in some real trading examples showing the Greeks. Delta Delta measures the rate of change of the option premium price to the change in the underlying currency pair.
For example, a delta of. Vega Vega displays the amount the price of an option changes when there is a 1 percent change in volatility. The forex trader needs to always observe if vega is ex- panding or contracting. If vega is expanding, this means volatility is increasing and vice versa.
Vega and time—Vega usually expands with time. Now if we go out to 53 days, look at what happens to vega see Figure 1. It expands, showing that volatility will increase over time. Gamma Gamma displays the percentage change in the delta for a 1 percent move in the underlying. High gamma values become important for those who need to hedge their positions using delta because hedgers need to be constantly rehedging to assure against changes in the delta.
When gamma is very high, it means that the potential profit due to a change in the underlying price is higher. We see an overlay of hills. All of the hills are centered and peak at the ATM. This is because gamma is highest at the ATM. This is what makes ATM options very attractive to traders. The ATM options move the most quickly when the underlying currency changes prices.
Of course, there is a price to pay for being ATM. The cost of the premium is higher than OTM. This leads to a reason to avoiding ITM options. ITM options are already close to 1. We see that positive gamma means that the delta will move up and, as a result, the option price will also move up. A trader trading a short-term expiration will have a harder time making money if gamma is low.
The trader wants a swift move. Gamma Long Position and the Yen A recent article in Bloomberg serves as an example of how gamma is viewed by professionals. All the options traded at an implied volatility of 16 percent, he said. Traders quote implied volatility, a measure of expectations for future currency swings, as part of pricing options. Traders who purchased options today probably did so to increase their exposure to gamma, according to Ryousei Ishida, senior vice president of foreign-exchange options in Tokyo at Mizuho Corporate Bank Ltd.
Theta has a well-known decay curve; the option trader who is a buyer is always worried about theta, while a seller has time decay on his side. However, the focus on theta be- comes more intense as time to expiration decreases. The rate of decay is not linear and is exponential.
In other words, when purchasing calls and puts, there is a negative theta, and the opposite a positive theta is true for shorting calls and puts. Once again at the ATM, theta has the highest value. The trader who wants to put on calls or puts trades when forex currencies have wider ranges, giving the currency the time to move through the range. It measures the sensitivity of an option to a 1 percent change in the underly- ing interest rate.
This is one of the least used of the Greeks. But during times when central banks are changing interest rate policies, rho can become a factor to consider. Also, if an option is greater than three months, there is increased interest rate risk: It becomes more expensive to hold. Interestingly, if a currency is in an interest rate—cutting environment, the options on that currency will tend to become less costly unless volatility increases.
For forex traders, rho is more important for longer-term options that go beyond a year. In this longer time frame, rho can affect the price of the option more significantly. The CME made this decision because the professional community of traders directly trade volatility. Spot Delta This Greek term relates to how much the option price changes in response a change in the underlying spot forex prices. It is the most important of the Greeks and there are many delta-related trading strategies the trader can become familiar with, which will be discussed in a later chapter.
The trader will primarily look at delta to help identify the ability of the option premium to move. A high delta means that the option premium will track more closely the move of the underlying spot currency. Delta ranges from 0. Calls have a positive delta, and puts have a negative delta. An option call or put with a 1. When an option is ATM or at the money, the delta is at 0. This means that the option premium price will move 50 percent of the movement of the underlying currency pair.
While deep-out-of-the-money options may be cheap, they are cheap for reason! For example, if a currency option is ITM, its delta may move closer to 1 as it approaches expiration, and deltas of OTM options would approach 0 as expiration came due. For those who are technically oriented, there are also forward delta and driftless delta measurements.
When the premiums of calls and puts with the same delta are not equal, the forex trader needs to be alerted to a skewing of the market sentiment. This should be taken into consideration on developing trading strategies. In the center is the ATM strike price. The 25 delta strike price for the put is The ATM is The volatility for the put is At this moment in time, the market shows more volatility for a downward direction but is still pricing calls more than puts, which shows market sentiment favoring the calls.
It is important to note that this skew is not a prediction of direction. Note that both options have the same expiration date of March 28, But that is not always the case. When the premium price does not go up, the forex trader confronts the phenomenon of a decline in implied volatility. Here is an example where the premium price hardly moves up!. The volatility of the first strike price is Practice this exercise over and over.
In this book, we concentrate only on options strategies that have predetermined and limited risk. This includes writing an option when it is part of a spread or combined with a covered position such as an underlying spot position. However, we are not discussing writing options as an isolated strategy. In this chapter, the reader learned about key elements of an option trade and how those elements are reflected in the nomenclature of the forex market. The reader also learned about how those elements provide clues to market sentiment.
A key concept is comparing call option premium prices with put option premium prices to detect which way the sentiment is skewing. Now that we have covered the essential components of forex option trades, we can move to the task of developing trading ideas. But the most important ones are time and volatility. In forex option trading, the factor of time is ticking away at the orig- inal option trade.
Known as theta, time can be an enemy or a friend. To buyers of an option it can be an enemy, because the longer it takes to maturity, the more things can go wrong and the option trade can either run out of time and never become profitable or, if it was profitable, can have time to reverse into losses. However, the longer it takes to get to maturity, the more time the trader has to be right in his direction. Often, prices have retracements, try to reverse, but turn around.
More time may allow the trade to work out. But to sellers of an option, time is a great friend. In Figures 2. Notice how the premium price changed. The premium price went up from to as the time to expiration changed from 22 days to 53 days.
American-style options allow for exercise at any time. This increases the uncertainty to the market, and therefore American style options usually are more expensive. Understanding volatility, even for the beginning forex option trader, is essential. When the weather is volatile, there are storms; when nations conflict with each other, the highest level of volatility is war. In trading, volatility is a mathematical concept that deals with the deviation of prices.
The change in prices over time is how volatility is measured. Technically, volatility is the annualized standard deviation of the log-returns. However, we are not concentrating here on the mathematics of volatility but on how it can be used by the forex trader and how it should be understood.
The at-the-money ATM volatility is 9. We can see in Figure 2. We know that the premium price reflects many variables and that volatility is a key component. This is because the market sees more risk, and therefore the option premium costs more. Notice that this is exactly what happened. A change in volatility from 9. What would happen if volatility decreased? Generally in the industry, volatility data is supplied by global financial data firms such as Tullet and Prebon, Superderivatives. Why Volatility Matters If there were no uncertainty as to the price of a currency pair in the future, there would be no volatility at all.
Uncertainty in the market leaves a visual track and can be detected if the standard deviation of the exchange rate increases. The average forex option trader needs to know why and how volatility matters. There are several very important features for forex trading. In general, the higher the volatility, the higher the premium the market will require. This is because when there is higher volatility the probability that the option will be in the money at expiration increases.
Volatility is easy to measure historically, but it is very hard to observe in real time what the volatility is, and it is even harder to predict whether volatility will increase. This is because there are so many variables that can im- pact future volatility, and no system in the world can identify all the variables. Therefore, the field of financial mathematics has come up with the term implied volatility because it is, in fact, only implied and is an estimate about volatility. The famous Black-Scholes equations assume a constant volatility, which is not the case at all in forex.
Financial mathematics professionals are always looking for and developing new ways to project an accurate volatility surface. One of the most useful and famous is known as the volatil- ity smile. The Volatility Smile In option trading, generally, volatility increases as the option moves away from the spot position or ATM position. The volatility smile graph a 2 or 3 2-dimensional plot of the im- plied volatility along different maturities but similar deltas.
It shows whether the market is favoring puts or calls. In Figure 2. Smiles can happen for many reasons, such as market fear of a crisis causing volatility to increase proportionally more on one side. There are important option trading implications associated with detecting a smile, which we will explore later on.
If possible, the forex option trader should access software that provides 3D volatility sur- faces. Many third-party software firms are now providing volatility surface visualizations. The 3D volatility surface has three axes; one axis has the deltas for the puts and calls, with the ATM in the middle. The axis next to it is the maturities can be from 1 day to 10 years.
The vertical axis displays the volatilities. The trader can see instantly whether the market is favoring puts or calls. For example, we can see in Figure 2. Used with permission. Now contrast this with the volatility chart for the Iceland krona in Figure 2. Notice its volatility is flat.
Trading Tip: When a volatility skew is favoring calls, think about a call ratio spread. When a volatility skew is favoring puts, think about a put backspread. Notice in Figure 2. The market sentiment for calls and puts is nearly the same. Theoretically, the premiums for the calls and puts should be the same. But if the price is greater on one side than the other, the market is said to favor that direction.
The full text can be found at www. Volatility Smiles and Becoming Cynical Traders in forex should be a bit cynical about the option prices that are offered by the forex firms, particularly if they are based on the Black-Scholes model. This is because, as noted earlier, the Black-Scholes assumes constant volatility across all strike prices for the same underlying price. The fact is that the market produces a skew in the volatility. This is called a volatility smile. When a trader finds a volatility smile, there is a bias in the market.
The trader should realize that the bias reflected in the smile reflects larger forces. Expect surprises in the underlying volatility, and this will affect probability of profits. Volatility Smiles at the Beginning of It will be valuable for students of forex option trading to compare the volatility smiles of the currency pairs over time. Did they change? How long did they last?
The purpose of this section is to give the reader a frame of reference for understanding volatility smiles. Try to answer the following questions: How long did it take for the currency pairs to move in a direction against the volatility smile bias?
What was the average time for such a reversal? Historical versus Implied Volatility The forex trader should constantly be looking for extremes in volatility. When volatility is at an extreme high or low, it contains information about market sentiment and direc- tion. It also is a signal of instability. A good place to begin to answer this question is by comparing historical volatility versus implied volatility.
Historical volatility is really statistical volatility measuring the actual variation in prices over time. When the prices widen in their range, the standard deviation rises, and this means that the historic volatil- ity will be higher. Traders use a varying time frame ranging from 1 day to 1 week to and day periods. Twenty days is a common time frame for looking at historical versus implied volatility. Implied volatility is an expectation of the volatility that the market is anticipating for a particular option during the life of that option.
The premium priced for the option reflects market sentiment about many things, and most importantly, the price reflects an implied volatility. This expectation is not perfect, and the equations generating them are not perfected. But the implied volatility is what the market is assigning at that moment, and it must be respected.
When comparing historical versus implied volatility, the trader can see if the im- plied is excessive over the historical. For example, a 1-month implied volatility chart should be matched with a 1-month historical volatility chart.
Historical versus Implied Volatility on Charts Figures 2. Look- ing at Figure 2. In forex option trading, 1-month volatility should not be the only period for evaluation. The common practice is to use a longer time frame such as 3 months. This was in contrast to the 1-month expansion of volatility. According to the theory of re- version to the mean, the trader could conclude that the 1-month gap is exaggerated. Therefore, this leads to trades favoring a contrac- tion of the volatility.
For example, if the trader thinks that historical volatility is too low and would increase, a good strategy would be to buy straddles. A good idea is to scan the historical versus the implied volatilities of the currency pairs. The trader should look for extremes. For example, in such a scan we found that the USDCHF had a scenario where the historical volatility was excessive versus the implied volatility. We can see that this spread was the widest in over a year on the chart below.
The trader would correctly anticipate a contraction of volatility. One month later, the volatility significantly contracted, as seen in Figure 2. The trader observing that the volatility was at an extreme would look to option strategies which benefit from a loss of volatility. One such strategy is the carry trade. Benefiting from a Loss of Volatility The carry trade is an option strategy that benefits from a loss of volatility.
One month implied volatility for the yen versus the dollar fell to A decline in volatility encourages carry trades as it makes the profit more predictable. Forex option traders should frequently scan the currency pairs comparing historical versus implied volatility. The key question to ask in reviewing historical versus implied volatility is: Which of these depicted currency pairs would you trade and in what direction?
Write down your reasons. The high volatility of the USDCAD suggests that the prices are unusually high in the underlying, further suggesting a sell strategy. Forecasting Volatility Changes While implied volatility is usually compared with historical volatility, it can also be com- pared with a projection of the volatility. A projection of volatility attempts to provide a leading indicator to the trader.
There are many technical analysis firms trying to do this for institutions. For example, in Figure 2. This forecast was based on the use of implied volatility analysis. The idea behind this projection is that the data showed that the implied volatility associated with that strike price was much higher This was considered very extreme and therefore to have a high probability of returning to a lower volatility level.
Once the trader can find this kind of projection, many different option trading strategies can be for- mulated, including hedging, writing options, and the like. Of enormous importance to those trading forex options is the emergence of ETFs on cur- rencies. These provide a greater amount of analytical information than readily available at forex firms. Forex traders should track all of the key currency ETFs. For example, Figure 2. This could be used as an indication to put on a long time spread—buy ATM call in January and sell ATM call in December , for example; comparing the slope of option volatility against a forecasted slope leads to further insights about which option strategies can fit market conditions.
Here is what Myron Woods of ORATS, the options analysis firm, says about this: A high forecast slope relative to implied slope indicates that a vertical spread in- volving selling a lower strike option and buying an upper strike option looks at- tractive, from the perspective of relative valuation of the implied volatilities of the lower strike versus the upper strike. In other words, the lower strikes i. The Volatility Cheapness Index The volatility cheapness index at Optima provides another useful way of spotting currencies that are in extreme modes of volatility.
The volatility cheapness index measures how implied volatility currently compares to the last five years of history of volatility, ranked on a percentile scale ranging from zero lowest to highest. We can see in Table 2. The Swiss franc was ranked lower, at We will identify these strategies in Part Two, but generally speaking, if volatility is expected to increase, then the option trader will look to play range-probing or range- breaking price actions.
Volatility and Price Movement—Sigma Boundary Charts In order to visualize what volatility actually implies for future price movement, it is useful to view a one-standard-deviation projection of price movement out into the future. This is called a sigma boundary chart. In order to do this, we simply take the current level of implied volatility, which is an annualized figure, and reduce it to shorter time frames, projecting the sigma boundary cone ahead from the current date.
In a normal data dis- tribution, the price movement will typically remain within plus or minus one standard deviation about two-thirds of the time, within plus or minus two standard deviations 95 percent of the time, and within plus or minus three standard deviations 99 percent of the time. By projecting a one-standard-deviation sigma boundary cone looking ahead, we can get a visual picture of the boundaries for price movement that the market is expecting.
Specifically, the options market in the implied volatility figure is forecasting a two-thirds chance that the price movement will remain within the one-standard-deviation boundary in the future. If a trader believes that the price movement is actually likely to breakout of that enve- lope, then the trader essentially believes that volatility is cheap and the trader may want to buy volatility.
By the same token, if the trader thinks the price movement will remain within the one-standard-deviation envelope, then the trader effectively thinks volatility is expensive and may want to sell volatility. The trader need not try to calculate the standard deviation of volatilities.
This is done for the trader by different analytical services. For example, Optima Investment Research generates standard deviation ranges for five currency futures pairs. This provides a use- ful source for linking volatility and price movement, and also for identifying resistance and support ranges since the market prices sometimes bounce off the one- and two- standard-deviation price levels see Table 2.
Seeing this, the trader would look to 1. There are several strategies. A range trading strategy reflecting this chart would suggest a sell of 1. The sigma charts provide a unique and quick way of targeting option strike prices based on volatility. Spotting a Volatility Cone If a trader spots a volatility cone, then there is an opportunity to detect and conjecture which options are overpriced or undervalued.
In the volatility cone chart in Figure 2. Source: Optima Investment Research, www. This allows traders to trade volatility directly. The concepts of historical and implied volatility were reviewed. Important vi- sualizations of volatility are also available to the trader, and software presenting volatility surfaces and smiles become important elements of trading options on the currencies. To help the trader, many software services are now available that offer sophisticated ana- lytics on volatility.
S It is a process resulting from an evaluation of market conditions. The selection process is very much subjective. To be successful, it requires that the trader adopt a preferred direction where he or she has maximum confidence in the result. Gaining confidence about a direction of a forex option trade involves understanding several di- mensions, explained in detail in Chapter 3. In addition, you will find an introduction to the binary options on the FOMC decisions as well as instruction on using housing sector data for developing forex option direction decisions.
Of all of the factors moving currency prices, this is the most important and will be discussed in greater detail later in this book. The following column appearing in Bloomberg is a typical example of commentary throughout the year regarding interest rates and a currency direction. To make a decision on anticipated direction, the forex trader can use the interest rate expectation calculator found at www.
DOWN 0. Technically, we mean the action the FOMC makes on the federal funds rate at its meetings. These are the interest rates paid on loans made between banks also known as depository institutions. The Federal Reserve therefore uses the policy tool of increasing or decreasing these loan rates to achieve policy goals. A currency will strengthen if the market perceives that there is reason for interest rates to increase. The market forms an expectation about the next central bank deci- sion on interest rates.
This expectation then governs the sentiment between central bank meetings. So the first thing that a trader needs to do is to group the world of currencies into three groups: currencies with interest rates expected to go up, currencies with in- terest rates expected to go down, and currencies with interest rates expected to stay the same. The forex trader must consider these correlations between interest rate ex- pectations and direction in shaping the duration of the trade.
There are now very effective ways of anticipating FOMC decisions that we will demonstrate in the next section. How can the trader answer this question and go beyond just guessing? Answering this question is the focus of a great deal of work throughout the world. For the readers of this book how- ever, there is a very effective way and it is in fact supported by official Federal Reserve Bank analysis. This important tool should be understood by forex traders.
The fed fund futures contract is cash settled to the simple average overnight fed funds rate for the delivery month see Figure 3. The basis for obtaining a strike price by the subtraction of the targeted rate — , allows for the market to bet not only on whether the FOMC will change rates but also on how incremental the change will be.
The options market can be used to estimate the probabilities associated with several possible paths for the target federal funds rate over the next several FOMC meetings. An important study concluded that options on federal funds futures provide a simple but powerful means for extracting market expectations for the possible outcomes of FOMC meetings.
In other words, the forex trader who wants to trade the FOMC decision can use the federal funds option information to help identify the probabilities involved in an impending decision. The trader has to be more quantitative about it.
A bet- ter way to express it is that rates can go down or up in increments of 25 basis points www. So our focus here is on presenting the best direct tool for enabling the trader to get an informed opinion about what the FOMC will do and also actually trade the FOMC decision directly! The forex option trader is very fortunate because the federal funds contract has a revolutionary option on it—binary options traded on the CBOT. A good source for review for those who want to become familiar with binary options on the fed funds is www.
Here is how it works. There are only two payout possibilities. The up-to-date settlement values can be found at: www. The target is converted into an option strike price. So a target of 4. In other words, the trade gets strike prices that allow an anticipation of what the FOMC meeting will do. The binary option is on the underlying federal funds rate directly. This contrasts with options on the average federal fund rate.
The contracts also cover the next four meetings, so it provides a longer time frame as well. Also there is no other outcome. The trader either gets or gets 0. In a regular option purchase, the risk is limited to the premium paid, but the gain can vary. Figure 3. We can see that the binary option limits the payout. A major advantage is that the binary option also limits the risk on writing the option.
A trader can in effect play the house and write an option and have no further risk other than owing the difference between what the trader receives premium paid by the buyer and The strike prices are then subject to being bought or sold written. If the trader writes a call at a strike price of The buyer of the 96 strike price is paying a premium and betting that the rates will be — 96, or 4 percent. The seller believes it will stay above that. The writer of the contract, unlike a plain vanilla option, will have a risk limited only to the difference between and the premium price he received.
Here on November 28 was the option price on the December 11 decision. The interpretation of the data below showed that the market is pricing the probability of a cut as 78 percent that the fun rate will be below 4. For more important information on binary options, refer to the following sources: r John B. Carlson, Ben R. Craig, and William R. If a trader believes that the FOMC will not do anything, he could write a call and write a put. The trader would receive the premium paid him, which is the most he would gain.
The trader would owe the difference between and the premium received if he were wrong. This indicates strong sentiment of a continued decline in interest rates. The power of the binary options is that it allows the trader not only to play a direct decision on the FOMC, but it gives the trader the ability to extract sentiment data and use it in his own trading. This option play allows the trader to trade more than just the next FOMC meeting.
He can trade a sequence of events. What if the trade thinks the FOMC will cut or raise rates one more time and then do nothing? A strategy here would be to buy a put or sell a call if the trader things rates would go up. Or if the trader thinks rates will go down and the FOMC will lower rates, he would buy a call or write a put.
For more information on the CBOT binary options on the federal funds rate, take a look at these web sites: r www. For example, here is the COT report on the British pound that indicates big money is neutral as to direction. Together with the volatility surface favoring puts, a trader inclined to trade puts on the pound has gained more confirming information. In the COT graph, as shown in Figure 3.
One of the most powerful capabilities offered to us by the COT is the ability to see a representation of market sentiment by the largest of players. In Figure 3. This is a representation of market equilibrium, using past experience as our gauge; this is generally indicative of two things: 1. Stagnation, as the market tries to determine the next new trend. A breakout will be fueled by both sides trying to jump on the next big move.
It trades on the Liffe Exchange. For exam- ple, the June contract price was at This translates into — This is an implied percentage and if the market was anticipating the EUR rate coming down, this contract would go up in value. But the trader can look at option data to derive some further confirmation regarding a consensus on direction. A weak housing market portends a decrease in rates while a strong housing market raises fears of inflation and, therefore, market anticipation of interest rate increases or at least not cutting rates.
The trader needs to keep an eye on key sources of housing data and develop a focus on key indica- tors and data for each currency pair. Luckily, there is a plethora of information available. KB Homes For shaping a directional opinion on the U. Its stock price is a leading indicator of the housing market strengths or weaknesses. We can see in Figure 3. A forex trader who wants to anticipate whether the FOMC will stop lowering rates or will increase rates will be on high alert if the price breaks its downtrend line.
We can see clearly that KB Homes, at the start of , began a downtrend, coinciding with weakness in the overall housing market. A put on the stock would correspond to a bet that U. This shows that the sentiment on the housing market recovery was significantly bearish. The forex trader should watch this ratio periodically to see if it changes. If the ratio swings toward the call side, the trader should carefully consider calls on the U. In , KB Homes had a The forex trader looking for a leading indicator of a housing recovery would want to see the price break the downtrend line.
The option would need to be longer term to give time for the economy to start recovering. It hit a high on December 27 of This data showed that the mood of the market was still very bearish see Figure 3. We can look at one more important piece of information regarding sentiment on this equity. We can compare the premium price of calls and puts.
If the trader were to shape an option trade on the recovery of this stock and its breaking of a downtrend, he might consider an April 19 option and determine whether it is indicating the same bear sentiment. Also, it is beneficial to be looking at the volatility data. The volatility of this option is If it starts declining, it could be a sign of a bottoming out. Leading U. The housing sector is a reliable indicator in almost every country that has a floating currency.
The British Pound This currency movement went to historic highs against the U. The cause was a fall in housing prices after a decade-long boom see Figure 3. We see a sharp skew in the implied volatility of the puts over the calls. Also, when looking at a the premium prices of options pips away from the spot price, we see a skew of the put premiums nearly twice the calls.
Finally, for those who have access to the data, the 25 delta risk reversals show also favoritism for the puts see Figure 3. Australian Dollar and Housing Data Another example of how housing data in- fluenced currency price direction and anticipation of interest rate decisions is that of Australia see Figure 3.
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