Trading Where You Think Prices Won't Go

02/10/2009 11:14 am EST

Focus: STRATEGIES

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

The market channels frequently, and this is tough on active traders because channels can be very difficult to trade. Sometimes these channels coincide with very important and widely anticipated news events. The pending passage of the stimulus and the bank bailout are great examples of this kind of situation. Traders are faced with a tight market that may or may not break out of its channel. In these situations, it might be easier to trade where the market won't go rather than where you think it will go.

Option sellers essentially trade this way all the time. Selling options is a great way to take a non-directional trade and turn the disadvantages of buying options into advantages. In the video below, I will cover some of the basic ideas behind selling an option in the forex and how that can work to your advantage as a trader in a channeling market.

Selling, or writing, an option means that you are opening an option trade by selling the option short. When you enter this trade, you are paid the option cost, or premium, up front. There are a few significant factors to consider as you evaluate and enter this trade. We will walk through each of these issues in a case study.

Selling the Option

Selling out of the money options is a great way to start using this strategy. Although it is perfectly acceptable to sell in the money options, new options traders will usually start the other way around because it is a little more conservative. The reason an out of the money is considered more conservative is that there are two market conditions that will result in a profit. First, the market could stay flat, which will result in you keeping the premium of the option you sold. Or, the market may trend the direction of your forecast and you will still get the maximum profit.

When trading spot FX positions, the market must move the direction you forecasted or there will be no profits, only losses. In the following example, you will see how selling an out of the money option gives your trade room to play without accumulating losses.

Our case study will be on the GBP/USD during the decline in January and February of 2008. The market had retraced to resistance on 1/30 (point A.) Forex traders would normally evaluate a short spot trade to take advantage of a move to the downside, but writing an option may be more attractive and provide a little more room for a volatile market. In this case, assume that a call was sold with a strike price 130 pips above the close price on 1/30 at 2.0000.

chart

It may sound a little unexpected to sell a call if you are bearish, but remember that now you are an options seller, and not an options buyer, so things are reversed. You want the market to fall so that the call you sold will fall in value or expire worthless. If you were bullish and wanted to sell an option, you would sell a put because you want the market to rise and that put to fall in value.

In the case study, assume that you sold a call with about two and a half weeks until expiration on 2/15, and that call is worth $145 for a $10,000 lot. That is the equivalent of 145 pips.

What you want in this trade is for the exchange rate to stay below your strike price until expiration. In the image, you can see two dotted line barriers that outline where you want prices to stay and within what time frame.

Let’s Review the Features of This Trade

1. You Are Opening the Position by Selling an Option

You are the seller of the option, which means that you are being paid the premium when you open the trade. You will lose money if the market rises above your strike price, but will keep the entire premium if the market closes at expiration on or anywhere below the strike price.

2. Break-Even Is Equal to the Strike Price Plus the Premium Paid

The premium you are paid can offset some losses if the market rises near expiration. Your break-even point at expiration is actually 145 pips above the strike price you sold (2.0145), because that is equal to the premium you were paid.

3. Time Value Works in Your Favor

This is an out of the money option with no intrinsic value. The entire premium is made up of time value, which melts or reduces the closer you get to expiration and the more the market trends down.

4. Exiting the Trade

You can exit this trade whenever you need to. If the market has fallen and the value of the call has declined to a desirable level, you can exit the trade by buying the call back for a cheaper price. You are then free to decide whether you want to sell another call for a larger premium. Alternatively, you can let the call expire on 2/15 when it has no value and keep the entire premium.

5. Margin

Selling a call means you have an obligation to cover losses that may occur if the trade moves against you. For example, if the market begins to rise, the call will gain in value and could become worth more than you sold it for. Most brokers or options dealers will require you to cover this trade with a margin requirement.

As a general rule of thumb, you are usually going to have to cover an options position with 20% of the notional value when trading exchange options, which is a leverage ratio of 5:1. Options offered by dealers usually have a much higher leverage ratio closer to spot leverage rates. If you are a very aggressive trader, working with an options dealer rather than a broker may be the best way to go.

Summary of Benefits

Selling forex options offers several unique benefits to the trader:

1. The market does not have to move to make profits. The market can remain relatively flat as long as it does not cross your break-even point and you will still be profitable.

2. Time decay works in your favor. As the option nears expiration, the premium, or cost, will fall every day, which creates profits for the options seller.

3. Options are as flexible to market conditions as outright spot positions. You can sell calls if you are bearish on a particular pair or sell puts if you are bullish.

Click here to watch the video.

By John Jagerson, of PFXGlobal.com and LearningMarkets.com.

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