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Forex options offer valuable protection in the currencies market - but are made
for institutions rather than individuals. So how can private traders get in on the
act? Robin Tracey has the answer
Anyone familiar with stock or
index options will know they
are generally liquid and are
traded on organised exchanges
such as LIFFE, CME, EUREX and
so on. These are quoted markets with market
makers making two-way prices. Most market
makers will offer two-way prices on
recognised strategies such as spreads and
butterflies.
The forex options market is not like this at
all. It is made by the banking system, with the
banks creating an OTC (over the counter)
market in an options strategy and making a
price on demand.
This of course makes it very difficult for the
retail trader to buy the 130 euro/dollar call at
£10 per point! Generally the banks will not
consider a trade unless it is worth at least
$10,000 of underlying. This means the
premiums on most trades are going to be
thousands of dollars, which is out of the range
of small traders. Also, as an OTC trade, it
might be easy to get in but you are limited in
your exit possibilities.
The forex market thrives on
exotic options and terms like 'knock
out' or 'double touch' abound, with
all sorts of fancy bespoke strategies
created by the large players. Often
the underlying market is influenced
by options, as large options
positions are often protected at key
levels. For example, the recent break
of the euro/dollar past $1.30 was
prevented for a while as players
defended short-call options at the
$1.30 level. These are called options
barriers and the euro was sold to
prevent this level from breaking. However,
once the level does break, these short calls
have to be unwound, causing a rapid
acceleration through the level in a similar
manner to stops being run in futures.
So how does the retail trader trade forex
with the limited-risk facilities that options
provide? In the UK the best method is via the
spread betters. However, remember that with
the spread betters, the gains are tax-free, but
the losses are not tax deductible. Also, the
options cash settle and the currency is not
deliverable. What does that mean?
With stocks, if you sell a stock X $10 put, if
the stock expires under $10 you will get
delivered the stock at $10 and you keep the
premium from the put, so it is a good way of
buying stock. The spread betters cannot
deliver the stock and they just pay the options
premium. The same is true of currency
options: spread betters cannot deliver you the
dollars and you have to settle the options p&l
in cash.
Options can be used to buy currency.
Suppose you want to buy $1,000,000 in one
month. At the pound/dollar one-month put
you would get $1.845, or pay 54.2p per dollar. If
you went to a bank and asked to sell a onemonth
54p put for $1 million you would
receive about 1.3c per dollar. At expiry if the
pound/dollar had gone up (cheaper dollars)
you would still receive $1 million at 54p per
dollar and get to keep the premium. If the
pound/dollar had gone down (more expensive
dollars) you get to keep the 1.3c and have to
buy the dollars spot. You make money in a
2.6c range around today.s price. Movement
outside that range and the strategy was not
worth doing.
Likewise options can be use to hedge
currency risk, or produce income. If you want
to buy currency at a rate and want to hedge
your risk you can buy a put to protect against
the downside risk. Alternatively, if you have
cash deposits you can sell calls against your
cash to supplement your interest. These
strategies can only be done with a bank.
Finally, there are daily binary bets on the
major crosses. A binary is an option bet that
only expires at value zero or 100. There will be
two bets, for example pound/dollar to close
the day up and the other to close down.
The bet opens with the up and down both
with value 50. As the pound/dollar cross rises
the UP bet moves up towards 100 and the
down bet towards zero. As the pound/dollar
cross drops, the down bet increases in value.
As the day proceeds the binaries work like
options and exhibit higher gamma
properties. If you find that either the up or
down bet is very cheap, say five, you could
buy it for say £50 per point, which gives a
maximum risk of £250, and if the cross
reverses and closes in the other direction the
reward would be 95 points, that is £4,500. A
very highly-geared fixed-risk bet.
So in summary, FX options are not really
available to the retail trader other than
through the spread betters but can be used to
hedge currency risk through the banks
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