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Option Hedging Strategies

  • #1
  • First Post: Edited 5:13pm Mar 22, 2007 11:56am | Edited 5:13pm
I am posting this thread that will hopefully turn into a resource for Forex Options strategies.

I have not used options in Forex to-date but would like to use then as a hedging tool for a spot position to reduce a potential loss instead of using stoploss orders. I can see that the advantage of hedging with Forex options instead of using a "stop" would be that we can stay in the market despite the movements against our spot position and still have an unlimited profit scenario. The disadvantage is that we would need a good risk reward system that has a larger gain in the spot position before we make a profit as we need to pay for the option premium.

Now as an example our trading systems gives us a signal that speculates that the exchange rate of the GBP/USD will decline over the next month. We sell 1,000,000 GBP on margin at the spot price of 1.8000. Now if we want to protect this position we would normally set a stoploss in case the GBP rises at possibly the daily ATR.

Now the other way would be to protect our position from a limitless loss using an option. As a holder of this option we will maintain the potential for an unlimited profit because our spot position can stay open until the excersise date of the option. If our spot position moves against us and stays there then the option will increase in value offsetting the spot losses giving us a total loss scenario of the option premium. So this scenario of an option instead of a stop loss order will allow us to stay in the market longer that would not be possible with a stoploss order. In a stoploss scenario we could find ourselves re-entering the market many times after rebounds, especially in a market with high volatility.

Please let us know if you use an option strategy as part of your risk factor when trading forex and the strategies that have been successful for you.
  • #2
  • Mar 22, 2007 6:51pm Mar 22, 2007 6:51pm
Markj,

Thanks for starting this thread. I am also interested in learn the ins and outs of FX options. I currently trade options on the stock indices.

Anyone out there have any resources for trading Options and brokers that have these for trading for the FX market?

Thanks
Pdhawan
  • #3
  • Mar 22, 2007 9:36pm Mar 22, 2007 9:36pm
I'm interested in following this thread as well. I have experience with trading options with equities, but not with Forex. I've looked into it, and the strategies I planned on using were very expensive. Buying Puts or Calls to hedge was very pricey.

I thought about trying to sell a covered call by going long on a position, and then selling a Call, but that didn't seem to be worthwhile either. The risk was too great considering the volatility of the pair.

How to investors profit from trading options on currency?



Frank
  • #4
  • Mar 23, 2007 8:37am Mar 23, 2007 8:37am
Hey Frank,

If it could work I'd be very interested. I am familiar with covered calls with equities. While i'm no expert the forex market is a lot more volatile, not sure if it could work the same.

Mike.

Quoting frank99
I'm interested in following this thread as well. I have experience with trading options with equities, but not with Forex. I've looked into it, and the strategies I planned on using were very expensive. Buying Puts or Calls to hedge was very pricey.

I thought about trying to sell a covered call by going long on a position, and then selling a Call, but that didn't seem to be worthwhile either. The risk was too great considering the volatility of the pair.

How to investors profit from trading options on currency?



Frank
Taking Life One Pip At A Time I officially have my own opinion.
  • #5
  • Mar 23, 2007 9:21am Mar 23, 2007 9:21am
Quoting frank99
I'm interested in following this thread as well. I have experience with trading options with equities, but not with Forex. I've looked into it, and the strategies I planned on using were very expensive. Buying Puts or Calls to hedge was very pricey.

I thought about trying to sell a covered call by going long on a position, and then selling a Call, but that didn't seem to be worthwhile either. The risk was too great considering the volatility of the pair.

How to investors profit from trading options on currency?



Frank
Frank,

Just thinking out loud here but If we had a greater risk reward ratio (R/R) wouldn't this offsets the premium cost and give us unlimited profit potential?
  • #6
  • Mar 23, 2007 9:24am Mar 23, 2007 9:24am
Quoting MikeC
Hey Frank,

If it could work I'd be very interested. I am familiar with covered calls with equities. While i'm no expert the forex market is a lot more volatile, not sure if it could work the same.

Mike.
One of the benifits of the option strategy would be that it would keep us in the market with high volatility rather than getting continually stoped out. But of course it seems if the price doesn't get away from our option price then we have a hard time covering the premium.
  • #7
  • Mar 23, 2007 11:48pm Mar 23, 2007 11:48pm
Mike,

Theoretically, if you are long GBP/JPY, and you sell a covered call for the pair, the pair should be able to drop as much as the premium before you lose money (plus the daily swap will help too). Ideally, it would be nice for it to go near the money but not into it so you don't get assigned. It costs too much to get into a 1 lot of GBP/JPY to begin with. The problem with GBP/JPY is the volatility. I've looked at other less volatile pairs, but the premium wasn't much. Maybe some of these others might be more worth it.

Again, I'm not an expert at Forex options, but from what I've been told, they should work similarly.


Frank
  • #8
  • Mar 23, 2007 11:53pm Mar 23, 2007 11:53pm
Mark,

I agree, that it should help. Were you referring to the idea of a covered call or hedging?

I will include some real option quotes if this will help those who don't have
access to pricing for options.

For Hedging:
Let's use USD/CHF as an example. A 1.2200 Put is currently in the
money.

If you were to buy an April 19th 1.2000 Put, it would cost $295.25.

That is for 1 lot or 100,000 units.

Covered Call:
Let's say you are long USD/CHF, and you want to sell a
covered call (assuming this is legitimate in Forex options).
Again, 1.2200 Call is in the money. If you were to sell a 1.2300
April 19th Call, you could get $278.94.


Frank





Quoting Markj
One of the benifits of the option strategy would be that it would keep us in the market with high volatility rather than getting continually stoped out. But of course it seems if the price doesn't get away from our option price then we have a hard time covering the premium.
  • #9
  • Mar 26, 2007 6:17pm Mar 26, 2007 6:17pm
Frank,

I hadn't given much thought to selling a covered call in Forex but it may be worth some investigation. I would think you would need to recieve a high premium to cover the volatility of the market.

Regarding the hedging strategy, I am still working on this within a system to produce a greater reward with a measured risk using an option strategy. I am working towards a three lot strategy with three seperate profit positions over a certain time.

I assume that there are few using options as a strategy in this forum.
  • #10
  • Mar 27, 2007 10:32am Mar 27, 2007 10:32am
I have a lot of experience with them, and the above post is correct, they are usually very expensive, and it is very important to make sure you buy them with a reputable broker. Some forex options platforms, due to the grey areas of forex regulation, will create their own market For example, if you want to spend $1000-1500 for a 1 or 2 month call option, (or bull-call spread), in the EUR/USD when the spot price is at 1.3300, one options broker may have the strike price at 1.35, while the other may have it at 1.37. Also their expiration dates differ greatly, as do their leverage. Also you need to understand that each of them usually adjusts the option value differently. I don't remember it all from my series 3 exam but it was called "delta" along with volatility measurements and stuff like that. They use different formulas to calculate the option value in relation to the spot price and spot movement, and I would assume they tilt the calculations in their favor. There are also not as many of these places left since the NFA and the CFTC have been cracking down on them for selling "deep-out-of-the-money" options to investors and charging super-high commissions on them. Just be careful using them as any stragtegy, much less hedging. Not trying to rain on your parade, but I personally have seen very few people have success with forex options, even in situations where the market and platforms were IN FAVOR of the client as far as fair option premiums and the like. Good luck to you regardless.
  • #11
  • Mar 27, 2007 11:26am Mar 27, 2007 11:26am
Quoting pipple
I have a lot of experience with them, and the above post is correct, they are usually very expensive, and it is very important to make sure you buy them with a reputable broker. Some forex options platforms, due to the grey areas of forex regulation, will create their own market For example, if you want to spend $1000-1500 for a 1 or 2 month call option, (or bull-call spread), in the EUR/USD when the spot price is at 1.3300, one options broker may have the strike price at 1.35, while the other may have it at 1.37. Also their expiration dates differ greatly, as do their leverage. Also you need to understand that each of them usually adjusts the option value differently. I don't remember it all from my series 3 exam but it was called "delta" along with volatility measurements and stuff like that. They use different formulas to calculate the option value in relation to the spot price and spot movement, and I would assume they tilt the calculations in their favor. There are also not as many of these places left since the NFA and the CFTC have been cracking down on them for selling "deep-out-of-the-money" options to investors and charging super-high commissions on them. Just be careful using them as any stragtegy, much less hedging. Not trying to rain on your parade, but I personally have seen very few people have success with forex options, even in situations where the market and platforms were IN FAVOR of the client as far as fair option premiums and the like. Good luck to you regardless.


Wait until actual forex options (with an underlying) are introduced to begin trading them, then they will be regulated.
  • #12
  • Mar 27, 2007 11:57am Mar 27, 2007 11:57am
Quoting pipple
I have a lot of experience with them, and the above post is correct, they are usually very expensive, and it is very important to make sure you buy them with a reputable broker. Some forex options platforms, due to the grey areas of forex regulation, will create their own market For example, if you want to spend $1000-1500 for a 1 or 2 month call option, (or bull-call spread), in the EUR/USD when the spot price is at 1.3300, one options broker may have the strike price at 1.35, while the other may have it at 1.37. Also their expiration dates differ greatly, as do their leverage. Also you need to understand that each of them usually adjusts the option value differently. I don't remember it all from my series 3 exam but it was called "delta" along with volatility measurements and stuff like that. They use different formulas to calculate the option value in relation to the spot price and spot movement, and I would assume they tilt the calculations in their favor. There are also not as many of these places left since the NFA and the CFTC have been cracking down on them for selling "deep-out-of-the-money" options to investors and charging super-high commissions on them. Just be careful using them as any stragtegy, much less hedging. Not trying to rain on your parade, but I personally have seen very few people have success with forex options, even in situations where the market and platforms were IN FAVOR of the client as far as fair option premiums and the like. Good luck to you regardless.
Thanks Pipple,

My purpose for the option strategy are purely to replace STOPLOSS in swing trade strategy. Have you had any experience in using options for this purpose?
  • #13
  • Mar 27, 2007 12:10pm Mar 27, 2007 12:10pm
Quoting Markj
Thanks Pipple,

My purpose for the option strategy are purely to replace STOPLOSS in swing trade strategy. Have you had any experience in using options for this purpose?
No, but I have had clients who did. The only way I've seen it work is to buy a put option at the same(or closest) strike price as you went long in the currency pair. So if you were long EUR/USD at 1.33, then I would buy an "at-the-money" put option at 1.33 strike. At-the-money options, like in-the-money options, can be expensive. In a perfect world it would even each other out until a direction is perceived and a stop get hit on one of them, but taking into consideration the calculations used for figuring option value--time left on contract, volatility, and such--I don't thing all things would work eqaully for some reason. I could be wrong, it might work, but I just wouldn't try it.
  • #14
  • Mar 27, 2007 12:11pm Mar 27, 2007 12:11pm
Quoting hidethereal
Wait until actual forex options (with an underlying) are introduced to begin trading them, then they will be regulated.
exactly
  • #15
  • Mar 27, 2007 4:02pm Mar 27, 2007 4:02pm
forex options are starting to be more and more popular, maybe one day it will even beat e-mini S&P 500
"Abandon all hope, you who enter here" La Divina Commedia, Dante Alighieri
  • #16
  • Dec 6, 2010 7:17am Dec 6, 2010 7:17am
Hello all

This thread has been a bit quiet for a while. Anyone interested in trading FX Options can open a demo-account at Ikon or Saxo Bank to gain some experience.

I haven't traded Fx Options systematicly but I'm looking into two different strategies:
1) To sell strangles (see Scattergoods thread on the subject http://www.forexfactory.com/showthread.php?t=194796)
2) To buy calls/puts as protection for a spot position for short term trades.

The last strategy could work like this:

EURUSD is in a downtrend and trading at 1.3300.
You sell 1 lot (sizing according to risk management) at 1.3300, and buy the equivalent amount as a Call Option at Strike 1.3300 (at the money), exp. tomorrow (so You have a day and a half to finish the trade).

The price to buy a Call ATM is approx. 50 pips. So now the price has to move 50 pips in Your favor on the spot position to be profitable. In a worst case scenario the price moves against You (or doesn't move at all) - so You've lost 50 pips on the Call which offsets Your loosing short position.
Though if You're able to gauge the general direction of the market there should be a fairly good chance that the price moves at least 50 pips in Your favor during the next day and a half.

If You set a modest target at 80 pips on Your spot position, then You are 30 pips in profit for the day. Once You've reached the target You can even be profitable on Your Long Call if the market reverses on You later.

When the EURUSD is having a daily ATR of about 120 pips, then it should be possible to get at least half of Your trades right. The big challenge is now that You need to be right on at least 75% of Your trades to be profitable overall with a 80 pip target.

Is anyone here able to program an EA to backtest the profitability of this strategy? You would have to use a trend filter to determine the overall trend, and then only open spot positions in the direction of the trend. And the EA would have to subtract 50 pips from the target to calculate the profit.
So if You go long on the open, a trade would end up profitable if the range of the current daily bar and the next bar for tomorrow is >50 pips.

The big question is. Where should You set Your target to become profitable overall? You're paying a huge premium to be in the trade for a start.
Then one might argue, that If You have a 75% confidence in every trade, then You might as well set a 200 pip stop loss on Your spot position instead of hedging. Then with a 80 pip target, You'll still be in 40 pips profit after 1 losing and 3 winning trades.

Suggestions anyone?

Cheers
Tomas
  • #17
  • Dec 6, 2010 9:08am Dec 6, 2010 9:08am
Personally I would concentrate on selling strangles. It can be extremely profitable. Scattergood's explanations in the thread mentioned above are excellent.

I use a similar method but base my sell decisions on standard deviations from the linear regression point rather than the currency strength meter that Scattergood uses. In order to maximise premiums I usually leg into the strangle from 45-30 days until expiry. I sell at 3 (60 day) standard deviations from the linear regression point once the current price is between 1 & 2 std deviations from the linear regression - if the chosen strike price is just past some support/resistance even better. Usually the price will turn around within a few days of entering the first leg so that I can sell the other side at a decent premium. My current favourite is USD/CAD. Quite a decent daily range to keep the premiums up, but generally going sideways over all.
  • #18
  • Dec 6, 2010 9:52am Dec 6, 2010 9:52am
Quoting skoda2008
Personally I would concentrate on selling strangles....
Skoda, thanks for the compliment about my thread!

I think your method of entry makes a lot of sense as well, especially using support and resistance.

How have your returns been? What brokers do you work with, as IKON pulled out of the US market I have been searching for the best brokerage solution. I find Saxo's spreads a little steep.
  • #19
  • Dec 7, 2010 2:37am Dec 7, 2010 2:37am
My account has grown on average by 30% per month, though in all honesty I have only been using this method on currency options for 6 months. However, I have been trading stock options for over ten years, but the margins on index options are no where near as favourable as currency. My worst month has still resulted in a 10% profit when I had to roll out to the next month on one leg. This was when I first started and was selling when the price was right at the regression point but selling 2 std deviations away. I have since revised that to selling at 3 std deviations, but in order to get a worthwhile premium have to leg in.

I'm using the NZ branch of Ikon FX, as I'm based in Australia.

EURCHF is set up perfectly as per my method right now. I'll post an example in the FOSS thread, later today, before I derail this thread too much...
  • #20
  • Dec 7, 2010 5:06am Dec 7, 2010 5:06am
Hello Skoda

Thanks for Your inputs.
Can You tell me what the typical spreads are at Ikon? At Saxo they are often 14-16 pips even on EURUSD.

And how do You decide on the position sizing? Are You allocating a certain percentage of Your capital for margin on any given trade, so that You can be in more than one trade at a time and enter when the setups present themselves?

Happy trading

Tomas
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