Ever since I first became a speculative trader in the financial markets, I always wanted to have a broad understanding of the various asset classes available to trade. When I first started, however, I was more about jumping into them because I wanted more markets to place trades on! To be honest I was a bit of a trading junkie in my first couple of years of trading and couldn’t ever really get enough of looking at the screens, doing my chart analysis and placing the trades themselves. Over time this did change as I grew to understand more about myself and of course, how the markets really worked. In fact, one of the most helpful things I did for myself was to switch down to trading just Forex for a longer period of time in an attempt to keep things more simple in my day to day activities in the markets. Once my trading plan was nailed down and I started to get some consistency in my trading, I then decided to reach back out to the other assets classes again, so that I could use them for specific styles of trading rather than jumping from one to the other like I did before.
It was easy to get to grips with the world of Futures trading quite quickly and I soon found myself using these markets to execute my day trades, kept an eye on the Equities markets for some longer term positions and carried on using Spot FX for day to day Swing trading opportunities. However, it was the world of Options trading which always 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, Strangles and Vertical Spreads, Options were always there in the back of my mind, waiting for me to embrace them in my own market speculation but only when the time was right. I had always known the there were many advantages to Options trading, like being able to get great leverage, increased risk to reward ratios, higher probabilities of success, more “hands off set and forget” trading and key opportunities to hedge and diversify which other asset classes are unable to provide.
I wanted to share this story with you because I have been moving more and more into Options trading myself and as a result, I have been looking into practical uses of Options in FX trading and I regularly get questions from students about the subject as well. I thought that it would be useful to go through a few basics on FX and Options and how they go hand in hand.
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 profit 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 really no different to this.
While I would never argue that options trading can be very complicated, like anything in life if you start with understanding them at the most basic level then you can gradually add their layers of complexity as and when you need them. Where most novice options traders hit a wall, is when they try to build complex strategies in options, which allow them to be directionally wrong and still make money. Does that sound a little too good to be true to you? Well then it probably is! Know this; options trading in any asset class requires a solid understanding of market direction analysis and risk management before anything else. If you do not have the ability to know when to buy and when to sell in any market and protect yourself if you are wrong, then options are just another way to lose money I’m afraid. Yet if you are already trading 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:
Above we can see a daily chart of EURUSD hitting a level of Supply at 1.3400 and then dropping down to a level of Demand around 1.3050 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:
I have attached a specific tool to my chart now for this example and it is an indicator which measures the volatility of the FXE on any given day. It does not provide us with a directional signal but does in fact allow us to see 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 has 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 as such and with options, when the insurance premiums are high, we can sell those policies just like any other insurance company in the world can do.
Trading currencies through options open up a whole new dimension to trading for the disciplined market speculator who has a good idea of how to time the market and while there are limited opportunities to trade options on FX, they are there if you know where to look. Join me in 2 weeks as I continue this introductory guide to the world of FX options and how to generate a return when the currency market is in standstill mode and not even moving at all.
All the best,