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. Whenever a call or put option is purchased, the strike price is either in the money (ITM), at the money (ATM), or out of the money (OTM). 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.
Since there is no “free lunch” in trading, the trader has a range of choices in putting on an option trade regarding increasing the probability of success. 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 1:1 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 are very common in hedging a position. 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. Let’s see why: By selecting a strike price that is away from the spot, the trader is anticipating the move. The hope of the forex trader is, of course, that the price will (during the duration of the option 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.
Wednesday, September 16, 2009
DIAGNOSING GLOBAL ECONOMIC CONDITIONS
Generally, the forex trader needs to anticipate the economic growth of the country or region associated with the currency. There are many locations to access up to date data on economic growth. Foremost among them is the central banks themselves. Once again, it is a question of timing. Economies move in cycles and take time to slow down or turn around. This is an area of great ambiguity for the forex trader. The trader has four decision rules:
1. Trade with the current economic cycle.
2. Trade a slowing down of economic growth.
3. Trade a stagnant economy.
4. Trade a growing economy.
If economic growth is projected to be slowing down, then the probability of the central bank’s increasing rates must be considered as declining. Central banks do not increase rates when growth is slowing down.
Also, the trader needs to consider the time frame for the option. The longer the time frame, the greater the risk of being wrong. But a longer time frame allows time for fundamentals to work out and express themselves in the price action. The forex option trader chooses a longer time frame to allow for countertrend moves to occur and then resume a fundamental direction. So, whether a forex option trade should be one week or several months is very much a judgment call. However, there are fundamental criteria for choosing a time of duration that should be considered. Depending on the economic conditions, forex option trades can range from very short term to longer term. Basically, a 3-month duration for an option trade will allow a reasonable period of time for fundamental forces
to express themselves.
1. Trade with the current economic cycle.
2. Trade a slowing down of economic growth.
3. Trade a stagnant economy.
4. Trade a growing economy.
If economic growth is projected to be slowing down, then the probability of the central bank’s increasing rates must be considered as declining. Central banks do not increase rates when growth is slowing down.
Also, the trader needs to consider the time frame for the option. The longer the time frame, the greater the risk of being wrong. But a longer time frame allows time for fundamentals to work out and express themselves in the price action. The forex option trader chooses a longer time frame to allow for countertrend moves to occur and then resume a fundamental direction. So, whether a forex option trade should be one week or several months is very much a judgment call. However, there are fundamental criteria for choosing a time of duration that should be considered. Depending on the economic conditions, forex option trades can range from very short term to longer term. Basically, a 3-month duration for an option trade will allow a reasonable period of time for fundamental forces
to express themselves.
GROUP CURRENCIES BY PURCHASING POWER PARITY (PPP) (BIG MAC INDEX)
Ranking currency pairs for the PPP is a valid use of fundamental data to detect if a currency pair is overvalued. The theory of PPP basically asserts that a good way to detect if a currency is overvalued or undervalued is to compare prices of similar products across countries. A well-known version is the Big Mac index. The idea is that a product like a McDonald’s hamburger should have the same cost in different countries. If one compared a global product such as Coca-Cola, the differences in prices in one country compared to another would demonstrate an imbalance in the currency value. To learn more about PPPs, visit the Organisation for Economic Co-operation and Development’s web site to read this article: www.oecd.org/dataoecd/61/54/18598754.pdf. (Source: Main Economic Indicators, pp. 280–81, March 2008, _C OECD 2008.)
Here is how the OEC defines PPP:
PPPs are the rates of currency conversion that equalize the purchasing power of different currencies by eliminating the differences in price levels between countries. In their simplest form, PPPs are simply price relatives which show the ratio of the prices in national currencies of the same good or service in different countries. For example, if the price of a hamburger in France is 2.84 Euros and in the United States it is 2.2 dollars, then the PPP for hamburger between France and the United States is 2.84 Euros to 2.2 dollars or 1.29 Euros to the dollar. This means that for every dollar spent on hamburger in the United States, 1.29 Euros would have to be spent in France to obtain the same quantity and quality—or, in other words, the same volume—of hamburger.
Economists predict that currency prices will revert to toward the level of purchasing power parity. The task of the forex trader is to access the PPP information in a timely way and use it to determine a potential direction for the trade. Since the process of reverting back to a mean PPP takes time, it is a perfect application of longer-term option trades. Let’s look at some recent PPP data that is easily accessible. The most overvalued currency was the Swiss franc, and the most undervalued was the Chinese yuan. The euro appears overvalued by 23 percent and the British pound by 18 percent. Based on the Big Mac theory, one would buy out of the money puts on the EURUSD, GBPUSD, and the USDCHF. In contrast, the Mexican peso, The British pound, the yen, and the yuan were undervalued, suggesting purchasing longer-term calls on these currency pairs. Where the strike prices should be can be suggested by the prediction that these currencies will retrace by at least 50 percent of the amount they are calibrated to be overvalued or undervalued. The duration of the options should be longer term than most, six months to a year! Of course, variations such as put and call spreads can be applied as well as combinations such as shorting the spot underlying and buying protective hedges.
1. The Big Mac Index, July 5, 2007, www.oanda.com/products/bigmac/bigmac.shtml
2. The OECD PPP data. Detecting very overvalued currencies based on OECD PPP parity measures can lead to longer-term option trades. Figure 4.5 depicts OECD data in a very accessible and understandable format and is available to anyone from the Pacific Forex Service. (Source http://fx.sauder.ubc.ca/PPP.html.) Figure 4.5 shows which currency pairs are overvalued and undervalued on December 27, 2007, based on OECD data. As a result, the forex trader can play a long-term reversion to the PPP equilibrium by buying puts and put spreads on the overvalued
pairs and calls and call spreads on the undervalued pairs. It is worthy to note that the yen and the New Zealand dollar are the closest to their equilibrium point. This suggests trades of a shorter-term nature.
3. UBS Data on PPPs. The UBS Bank also provides frequent updates on PPP values.
Their data showed that the GBPUSD and AUDUSD were overvalued and that the USDNOK were undervalued. (Source: www.ubs.com/1/e/ubs ch/wealth mgmt ch/research/rates.html.)
Here is how the OEC defines PPP:
PPPs are the rates of currency conversion that equalize the purchasing power of different currencies by eliminating the differences in price levels between countries. In their simplest form, PPPs are simply price relatives which show the ratio of the prices in national currencies of the same good or service in different countries. For example, if the price of a hamburger in France is 2.84 Euros and in the United States it is 2.2 dollars, then the PPP for hamburger between France and the United States is 2.84 Euros to 2.2 dollars or 1.29 Euros to the dollar. This means that for every dollar spent on hamburger in the United States, 1.29 Euros would have to be spent in France to obtain the same quantity and quality—or, in other words, the same volume—of hamburger.
Economists predict that currency prices will revert to toward the level of purchasing power parity. The task of the forex trader is to access the PPP information in a timely way and use it to determine a potential direction for the trade. Since the process of reverting back to a mean PPP takes time, it is a perfect application of longer-term option trades. Let’s look at some recent PPP data that is easily accessible. The most overvalued currency was the Swiss franc, and the most undervalued was the Chinese yuan. The euro appears overvalued by 23 percent and the British pound by 18 percent. Based on the Big Mac theory, one would buy out of the money puts on the EURUSD, GBPUSD, and the USDCHF. In contrast, the Mexican peso, The British pound, the yen, and the yuan were undervalued, suggesting purchasing longer-term calls on these currency pairs. Where the strike prices should be can be suggested by the prediction that these currencies will retrace by at least 50 percent of the amount they are calibrated to be overvalued or undervalued. The duration of the options should be longer term than most, six months to a year! Of course, variations such as put and call spreads can be applied as well as combinations such as shorting the spot underlying and buying protective hedges.
1. The Big Mac Index, July 5, 2007, www.oanda.com/products/bigmac/bigmac.shtml
2. The OECD PPP data. Detecting very overvalued currencies based on OECD PPP parity measures can lead to longer-term option trades. Figure 4.5 depicts OECD data in a very accessible and understandable format and is available to anyone from the Pacific Forex Service. (Source http://fx.sauder.ubc.ca/PPP.html.) Figure 4.5 shows which currency pairs are overvalued and undervalued on December 27, 2007, based on OECD data. As a result, the forex trader can play a long-term reversion to the PPP equilibrium by buying puts and put spreads on the overvalued
pairs and calls and call spreads on the undervalued pairs. It is worthy to note that the yen and the New Zealand dollar are the closest to their equilibrium point. This suggests trades of a shorter-term nature.
3. UBS Data on PPPs. The UBS Bank also provides frequent updates on PPP values.
Their data showed that the GBPUSD and AUDUSD were overvalued and that the USDNOK were undervalued. (Source: www.ubs.com/1/e/ubs ch/wealth mgmt ch/research/rates.html.)
THE CURRENCY OUTLOOK CHECKLIST
This section will present a set of strategies and analytical steps to accomplish this result. There are many dimensions that define the optimal condition for a forex option trade. Certainly, foremost among them is the nature of the price action. But at the start of the process is the overall fundamental environment of the price action. It is essential for the
trader to develop a currency outlook for all of the currency pairs. In order to do this, the trader can use the following currency outlook checklist to establish a framework for deciding on the direction of a currency pair. The currency outlook checklist serves to keep the forex trader accountable to assessing fundamental issues. These are too often overlooked. The forex trader will greatly benefit by being able to complete this checklist. Some traders will look to be very detailed, while others will be more cursory in their decision process. Ultimately, anticipating a direction is the key first step in developing a forex option strategy.
Currency Outlook Checklist
1. Expected Economic Growth
Negative
Slowing
Uncertain
Steady
Slow growth
Fast growth
Decelerating
2. Inflation Latest
Central bank target
Actual target
3. Sentiment Indicators
Consumer sentiment
Manufacturing sentiment
Market Sentiment
4. Possible Recession
Housing starts
Home price
Yield curve inversion
5. Central Bank Interest Rate Policies
Lowering rate mode (.25 basis points, .50 basis points)
Nothing
Increase (.25 basis points, .50 basis points)
Binary option sentiment
6. U.S. Dollar Sentiment
Central bank currency reserves of dollars
U.S. dollar index
Trade-weighted index
7. Commodity Markets
Gold
Commodity index
Oil
8. U.S. Dollar Data
% Dollar holding of currency reserves of central banks
Foreign ownership of U.S. Treasuries—declining
trader to develop a currency outlook for all of the currency pairs. In order to do this, the trader can use the following currency outlook checklist to establish a framework for deciding on the direction of a currency pair. The currency outlook checklist serves to keep the forex trader accountable to assessing fundamental issues. These are too often overlooked. The forex trader will greatly benefit by being able to complete this checklist. Some traders will look to be very detailed, while others will be more cursory in their decision process. Ultimately, anticipating a direction is the key first step in developing a forex option strategy.
Currency Outlook Checklist
1. Expected Economic Growth
Negative
Slowing
Uncertain
Steady
Slow growth
Fast growth
Decelerating
2. Inflation Latest
Central bank target
Actual target
3. Sentiment Indicators
Consumer sentiment
Manufacturing sentiment
Market Sentiment
4. Possible Recession
Housing starts
Home price
Yield curve inversion
5. Central Bank Interest Rate Policies
Lowering rate mode (.25 basis points, .50 basis points)
Nothing
Increase (.25 basis points, .50 basis points)
Binary option sentiment
6. U.S. Dollar Sentiment
Central bank currency reserves of dollars
U.S. dollar index
Trade-weighted index
7. Commodity Markets
Gold
Commodity index
Oil
8. U.S. Dollar Data
% Dollar holding of currency reserves of central banks
Foreign ownership of U.S. Treasuries—declining
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