Forex Options Strangle System

Hi all,

I wanted start a thread to discuss a Forex Options Strangle System (FOSS), as I have been applying a similary system to equity indexes for the last year with good success. I have become a pretty conservative trader over the last few years and focus as much or more on how not to lose and how to reduce drawdown as I have been on maximizing returns. You have to survive in order to fight another day. Thus, on index options, over the last 7 months I am up 16% with no more than a 2% draw down on a monthly basis.

Because of that success, I have been trying they strangle system on forex in a paper account. In the last two months I am up 18% with 0% draw down on a monthly basis. However, I am unclear whether that was skill or that was luck. Hopefully a good discussion here will flesh out which it was and how to replicate it.

What is a Strangle and how do you make money with it?
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The purpose of this section is to discuss exactly what is a strangle and how one makes money at it. A strangle is simply:

1) Buying or selling an out of the money put and out of the money call on the same instrument with the same expiration.

Buying a Strangle:
ASSUME: EURUSD @ 1.42500
Buy 100,000 EURUSD Call @ 1.4500 Nov 19 Expiration = 0.0200
Buy 100,000 EURUSD Put @ 1.4000 Nov 19 Expiration = 0.0206
Total cost: 0.0406 x 100,000 = $4,060

Now basically you are 406 pips in loss on the trade at the start. So your break even is:

1.4500 + 0.0406 = 1.4906 or
1.4000 - 0.0406 = 1.3594

You then make $10 a pip above or below those two values. The interesting thing with Buying or being Long a strangle is you don't care which way the price moves, just that it moves.

Selling a strangle:
ASSUME: EURUSD @ 1.42500
Sell 100,000 EURUSD Call @ 1.4500 Nov 19 Expiration = 0.0190
Sell 100,000 EURUSD Put @ 1.4000 Nov 19 Expiration = 0.0196
Total revenue: 0.0386 x 100,000 = $3,860

You get to keep all the revenue as long as the EURUSD stays between 1.4500 and 1.4250. This is probably too tight a range, but the idea is understandable. You want to not be wrong, you want the price to stay within a range and keep the premium.

How does margin work with strangles?
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If you are buying a strangle you need the amount of cash in your account to purchase the full amount of the strangle. In the example above, you would need $4060 in your account to buy the strangle.

If you are selling strangles, you get a ton of leverage. However, before we go into the formula we need to talk about delta. Delta is the rate of change for every point up the currency makes. For an At the Money (ATM) option, delta is around .50. Meaning that the option changes price 50% of the price move. So if the EURUSD goes up 100 pips, the ATM option price goes up 50 pips.

Now, for margin on forex options the formula is:

2% x Delta x Size of trade.

For an ATM 100K EURUSD option, the margin would be around:

2% x .5 x 100,000 = $1K

For an OTM 100K EURUSD opiton, the margin is much different as delta is different. A way OTM option may have a delta of .1 so the margin is:

2% x .1 x 100K = $200

Now here is where things get interesting, delta is netted out on all your positions. What this means is that if you have sold a Call and Sold a put, you net delta is the Call Delta + Put delta, which can appoach zero if they are evenly spaced. Also, you can only really reserve margin for one side of a strangle. Thus if you are short a Call and Short a Put, you only have to use margin for either the Call or the Put as you can't be wrong on both. So as the currency price moves towards one strike, you really get double margin as you only reserve margin on one side.

What is the FOSS?
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I SELL option strangles in order to capture theta, or the time decay in the value of the option. Every day that passes the option value decreases a little, just as the option value changes either up or down as the price of the currency changes up or down.

Since the margin rules are very advantagous, you can really make some money. I sell a strangle, 3-5x the ATR of a currency some 20-40 days out and wait. I look for support and resistance lines and try to sell them just outside of those lines so I have some built in price protection.

But the big question is what to do when I am wrong. When the price moves towards one of my strikes? Well, in that case I just eat the loss and buy back the option, and immediately turn around and sell another one, further out of the money, further out in time, and a little smaller, basically just looking to make back my loss. Since if I lose on one side, I keep all the money on the other.

Open Issues
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So what is there to discuss? The big question is what is the best method to determine where prices WILL NOT GO TO. This takes a bit of reverse thinking as usually traders worry aobut, and make money, based on predicting where the price will go.

Example trade
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So here is a live trade I just made:

GBPUSD: 1.6150
Sell 100,000 GBPUSD Call @ 1.6700 9-17 expiry = 0.0016
Sell 100,000 GBPUSD Put @ 1.5550 9-17 expiry = 0.0016

I have a slight downside bias on the GBPUSD and thus extended the lower strike by 50 more pips. Currently to hold this position I am using $300 in margin, but at the strikes will use no more than $1000 in margin for both legs.

In other words if the strangle expires I make $320 on between $200 and $1000 of margin. If I have to roll on leg because the price approaches the strike, I keep $160 on $1000 of margin at the time of the roll (assume the price doesn't come back to the lower strike. Those kinds of returns per trade are pretty great, even if you are wrong on one side.
A screen shot is attached.

So again any thoughts or ideas on how to predict where a price of a currency won't go would be greatly appreciated.

Hi there,

This sounds rather interesting. I only have a limited amount of experience with options - I used to price swaptions (options based on interest rate swaps).

Mainly plain vanilla, so straddles and strangles are somewhat familiar.

Can I ask who you are using for pricing and execution?

regards
daytrading

The two most prominent retail forex options brokers are Ikongm, and Saxo Bank. I prefer Saxo's platform, but Ikon's spreads are better. Not great, but better than Saxo's.

You will pay 10 pips on the spread, but better than Saxo's 12-15!

www.ikongm.com -- Core Options platform.

Thank you.

I am familiar with Saxo's FX platform.

How do you pick you trades? Do you have a way of tracking what type of ITM OTM ATM options are the best value at a particular time?

regards
daytrading

This is the key question. I had been looking for a move off a high or low coming into a fibo area. I do this because if it is the initial move, you would expect a counter move to come.

Let's say the EURUSD rallies from 1.4000 to 1.5000 and then comes back down to 1.4500. I would expect another up / down to appear in the coming days (assuming no big data releases ..NFP, Fed announce, etc.) . And thus I would look for a 1.3800 / 1.5200 strangle assuming there was support / resistance in those areas.

I guess you could say I was using the expectation of some waves to unfold and support / resistance to define the strikes.

Do you have a preference as to the length of the option (because of premium) or do you have it taylored according to expectations in the cash market?

regards
daytrading

My preferred expiration is 30-45 days out. This is because of how theta works. Theta is the rate of decay in the price of an option for the passage of one day.

Let's say you have a 100 day option that you sold for 100 pips. If nothing else changed (price of underlying currency, interest rate, volatility), the next day you only have 99 days left so he price of the option to buy it back should be about 99 pips. So theta would be around 1%.

Now lets say you have a 50 day option that you sold for 100 pips. In the same scenario, with the passage of 1 day, the cost to buy it back should be 98 pips, since you have lost 1/50th of the time in the option vs 1/100th.

Around 32 days is where theta, or time decay, accelerates noticeably or exponentionally. Thus I try to sell options just before that acceleration occurs.

Hi,

30-45 days as in bond-basis or trading days, which would equal approx. 2 month?

I am asking to get a better idea of the cash time frame we're looking at.

Also, does the theta situation apply in the same way across different currencies and in the same fashion throughout the year?

regards
daytrading

Nope, calendar days.

I have one question
If i open a eurusd options sell call at strike price of 1.4 and spot price is 1.4674
the premium is high...
so my question is when will i get the premium at EXPIRY ONLY??(IF I HAVE SET THE EXPIRY TO BE THE NEXT DAY..)
what will happen if at the expiry the spot is 1.4600 or 1.4700....


the thing is i want to know the explanation of strike price bcoz if i want more premium i can put lower strike price but what happens at expiry???

That's not quite how it works.

If you sell the 1.4600 EURUSD Call when the EURUSD is trading at 1.4674, you should be able to get 74 pips + some amount of time premium. The total you can sell it for let's ASSUME is 100 pips.

You get 100 pips in your account immediately. However at expiration you will have to sell the EURUSD at 1.4600. Thus if the EURUSD is at 1.4750 at expiration you will be down 150 pips on the position, but having collected 100 pips for the call you will net down 50 pips.

What you are doing is selling and In The Money call (ITM) and thus it has both Intrinsic Value and Time Value. The Intrinsic Value is the amount between the current price and the strike. In the example you gave that was 1.4674 - 1.4600 or 74 pips.

The call also has some Time Value, which varies on a number of factors. The combination of Time Value and Intrinsic Value determine the total option premium

Margin is calculated as:


Total Position x .02 x Net Delta


So in the example you gave, the numbers aren't quite right. You cannot really have a put and a call with both positive delta. If the price of the EURUSD goes up, the call's premium goes up, but the put's premium goes down. And if the EURUSD goes down, visa versa.


Thus, in your example you would have nearly a zero delta and need nearly zero in margin. The important thing to remember is that as the pair's price moves towards one of the strikes of the call or the put, the net delta on the position approaches .50.

How much to keep in your account, I can't really say. I mean it depends on risk tolerances, how much in other positions you may take, etc.

good one.........

Same here, good posting!

We like to invite Scattergood (Josh) to come back to continue this thread.

I am happy to answer whatever questions people have, and to explain what I am doing.

To give a little summary, I started live trading Strangles on Forex on the 1st of September of this year. So far I am up 34% on a mark to market basis.

If all my options expire, and they go out to 12/17/09, then I'd be up around 55%.

The leverage on this stuff is amazing, and the loss control is pretty straight forward.

In fact here is a repeat of a post I did in another options thread here on ForexFactory:
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OK, here is a chart with information about a USDJPY strangle I have legged into. I sold the put first, then after a few days sold a call.

Here is a legend for the chart:

1) The left most vertical red line is the date I sold the first leg, the put in this case on 10.16.09.

2) The right most vertical red line is the date of expiration of the put (and call) that I sold, which is 11.19.09.

3) The lower black line and text show the put sale. There is a description of the sale and the start of the line is the day I sold it and the end of the line is the day it expires.

4) The upper black line and text show the sale of the call. There is a description of the sale and the start of the line is the day I sold it and the end of the line is the day it expires.

5) The thin blue line is a resistance line I saw being rejected which was one indication for me to now sell the call.

6) The bottom panel contains a custom indicator that measures the internal strength of each individual currency of a pair. The red line measures the strength of the front currency, the USD, and the green line measures the strength of the back currency the JPY. The histogram is the difference between the red line (USD) and the green line (JPY). PM me if you are interested in the indicator.

OK, now here is the thinking behind putting on each leg of the trade:

A) On 10.16.09 you can see about 8 previous days of rise in the USDJPY, including a small retracement from 90.50 to 88.50 in the middle of the 8 days.

B) Further you can see a falling JPY in the Multibar indicator on the bottom panel, and a flat USD. The difference, or histogram, has been steadily rising after an extended month+ of negative values.

A + B indicate that there is significant likelihood of continued rise in the USDJPY. So I selected a Put strike well below the swing low. In fact 86 is below the December 08 and Jan 09 lows of 86.50 or so. This seems like a reasonable lower strike as it has shown itself to be below significant support in the past.

C) 12 days after selling the 86 put, there was a significant decline from 92.25 down to 90.25.

D) This decline started very close to a previous swing high of 92.50 or so as indicated by the blue resistance line.

E) Further, the internals indicator at the bottom shows the JPY has turned up as the green line moves up, and the histogram difference has started to turn down from a small positive value.

C + D + E indicate that a swing high may be in place and that we have started the down, in a down up down move before we get good direction again. So I put on a short 94 Call above the swing high above resistance line the price just moved away from.

All combined, I collected 39 pips on a 2 lot, or around $800. The max margin I would ever have to have on is around $2000 if the USDJPY ever got to either strike.

The max amount of loss I would have to absorb is around $2500 before rolling things out. If the USDJPY shot up to 94, the upper Call strike, the Call I sold for 15 pips would be worth about 135 pips. This 125 pip loss on 2 lots would have to be absorbed, and then rolled out into the future.

So, worst case is I need 2000 + 2500 = $4500 to collect $800. That's a 17% return. I may get that return in 30 days if both options expire. It may take 6 months if I have to roll one of the options out and eat the loss but sell another option.

Either way, 17% on 30-180 days seems pretty good to me. If you have any questions, I am happy to address them, just let me know.

I don't quite understand it on your 1st post in this thread, you mentioned:

"Thus if you are short a Call and Short a Put, you only have to use margin for either the Call or the Put as you can't be wrong on both. So as the currency price moves towards one strike, you really get double margin as you only reserve margin on one side."

So, if my Sell Call is $600 (delta=0.2) and my Sell Put is $650 (delta=0.2):
My margin total is only $650, Is that what you implied?

However, I checked with my Option Broker about my deposit before opening trades: how much is safer for this Sell Call & Sell Put strangle?
His answer is 5 times of margin total $600 + $650 = $1,250 is better.

Forex option margin is kind of complicated, so let me try a full description:

Starting Balance in Account: $10,000
Sell 1 100K Call for .0025: +$250
Sell 1 100K Put for .0030 : +$300
======================
Cash in the Account: : $10,550

Now we have to look at what it costs to buy the options back, assuming a 10 pip spread:

To buy back Call at .0035: -$350
To buy back Put at .0040: -$400
=======================
Total to buy back options: -$750
Cash in the Account: $10,550
========================
Account Liquidation Value: $9800

Thus we have a $200 open loss on the options we had sold.

Now let's look at the margin we need to support the position. There will be three points I will look at margin:

1) Assume the Put and Call are equidistant from the underlying:
Call Strike = 1.5000
Put Strike = 1.4000
EURUSD = 1.4500

In this scenario, the Call Delta should be around .14 and the Put Delta should be around .13. But the put delta is really a NEGATIVE delta. For every 100 pips up the EURUSD moves, the Put will lose 13 pips of value. Thus the net delta on your position is about 0.01.

So margin should be: 200,000 x .02 x .01 = $40 (est)

Remember, this is only TO PUT THE TRADE ON.

2) Assume the underlying is near the Call strike:
Call Strike = 1.5000
Put Strike = 1.4000
EURUSD = 1.5000

In this scenario, your net delta will be around .47. The Call's delta will be around .5 and the put's around .03. I just assume delta at a strike is around .5 making margin:

200,000 x .02 x .5 = $1000 (est).

However you have to think about the open loss you now have on your position. The Call you sold for 0.0025 will cost you maybe .0100 - 0.0150 to buy back depending on volatility and time. So you will be down 75 to 125 pips (again an estimate).

So besides having the $1000 in margin to make sure you have, you need to absorb a $750 - 1000 (or more) loss in your account.

But remember you only have to absorb say $1000 in loss on a 500 pip move in the underlying, which usually would mean a $5000 loss on a normal full lot directional trade.

This is why calculating how much money to have in the account is a little more complicated.

Scattergood,

Clear on scenario 1 (equal distance), not 2 yet.
Will practice on demo option account to see.

However, for scenario 1, like your example, est $40 is the total margin:
How much do you think safer to deposit for EURUSD to open this kind of trade?

Thanks.

Scattergood,

Also, for scenario 1 (equal distance) short strangle:

Better if I set it up by the delta, say Sell Call at delta=0.2 and Sell Put at delta=0.2?

OR

Better if I set it up by pips distance, say Sell Call at 400 pips above the current strike, and Sell Put at 400 pips below the current strike?


Do you have the experience to share it?