Option Hedging Strategies

The spreads are fixed at 10 pips no matter which currency/metal you trade. Some are dealer quote only others are auto-execution with guaranteed fills (up to several million) for several strike prices around the current price. I stay away from the ones which are not auto-execution, which does limit things a bit, but I still have not had a shortage of trading opportunities. Sometimes the dealer quotes take 10 or more minutes, then you only have a few seconds to accept it.

Generally I divide my account into 4 equal portions so that I can have 4 trades going at once. I try and start with a strangle but like to have enough for 2 more positions left over. Often single leg trades (in and out in a few days) that are just too good to pass up come along throughout the month. With the single leg trades I prefer to sell an option rather than buy/sell spot forex as I am making money whether the price is going sideways, the way I expect or even a bit against me.

I could open more positions, but I like to keep things under control, even with 4 positions open and everything going against me the most margin I've had to put up is 30% of my account. I base my monthly profit figures on my total account value (as it's money I've set aside not to be used for anything else), but if I calculated my profits based on the margin I've actually put up the figures would be substantially higher.

Thanks a lot for Your reply Skoda. It sounds like a pretty solid strategy with a solid return.
I'll check Ikon out later to see what they can offer in Europe.

Happy trading.

Tomas

What if before tomorrow your SL on the spot forex gets hit? I.E your call option is right (for now) but the SL gets hit. How much is the SL that you used? Also, the call option is not won, because its before the expiry, and when it does it close below the call, so you loose twice or both ways ?

Thanks.

Hello CSPIP

The idea of the hedge strategy is not to win on the option before or at expiry, but it is to win on the spot position which is in the opposite direction of the option.

My anticipation is that the downtrend will continue, so I'll sell a spot position to profit from that. But instead of putting a stop loss on the spot position, I buy a call in this case to protect my position.
I want the Calls strike price to be at the money (ATM), which is at the price I sold the spot. So even though the spot price reverses on me and goes an unlimited amount of pips in the opposite direction I am still protected by the option.

Loss scenario:
I sell 100,000 EURUSD at 1.3300.
I buy a Call (100,000 EURUSD, strike 1.3300) at the same time for a premium of 50 pips.
If, at the time of expiry, the price has moved to 1.3500 I will then have a net loss of 50 pips. The 200 pip loss on the spot is being zeroed by the 200 pip gain on the option.
So at the time I enter the trade I pay a "stop-loss" of 50 pips (the option price) up front, and my only chance to get break even is if the price moves at least 50 pips in favor of the spot.

Win scenario:
I sell 100,000 EURUSD at 1.3300.
I buy a Call (100,000 EURUSD, strike 1.3300) at the same time for a premium of 50 pips.
.... Price moves in favor of the spot. I now have 2 different ways to play it:

1) Set a limitorder to exit my spot position at a certain profit. In this case more than 50 pips away from the entry to offset the premium paid for the option.
Doing this I limit my profit, but I can be certain that if price reaches this target I am profitable in the overall trade. And if the price reverses after reaching my target I might even be profitable on the call option when it expires.

2) If the trend is strong I may let it run until expiry of the option, and it is still possible to lock in some profit by setting a stop-loss on the spot position AFTER price has moved more than entry price + premium paid.

The overall advantage of this strategy is that price has more room to move against the spot position without being stopped out when I'm hedging through an option. If I'm risking 50 pips using an ordinary stop loss to protect my spot position, then of course I'm out of the trade even though price only temporarily moves more than 50 pips against the intended direction.
The setup was not perfect for a short at the time I wrote my post last monday (so I didn't take the trade), but You can se on the chart below, that price actually reversed 100 pips and eventually came back in positive territory. If I had entered the trade at 1.3300 (the red arrow), I would have been stopped out if I had used a 50 pip stop-loss on the spot, but I would have stayed in the trade if I had bought the call option.
Price did come back below 1.3300, but not enough to make the trade overall profitable before expiry. I could have placed an ordinary stop-loss at the entry price at the time of expiry and waited for price to go lower. It wouldn't have been a free trade at this time, because I had still paid 50 pips for the option that expired, but I would still be in the trade.

Another possibility in this setup is to purchase an option with and expiry date further out in the future, however price then has to move even longer from Your entry to be profitable because of the options extrinsic value (time value).

Happy trading.

Tomas

I'm not sure if it's a part of Your question, but anyways just to clarify:
The way to profit from a long call or put before expiry is to sell the opposite side of the option at the market price. However this should not be a part of a hedge (spot position + option) as described previously, but only if you buy a put or a call.

Example:
I buy a EURUSD call (strike 1.3300) and price goes to lets say 1.3500 before expiry. I can't exercise the option, but I can sell a Call with a strike price of 1.3500 with the same expiry date. I have now locked a profit of 200 pips minus the spread (of the option) and the premium paid for the long call.
So the result is two positions a long call and a short call with the same expiry date and a locked in profit. No matter where price is at expiry I have my profit locked and two positions that will balance each other out.

In addition to my earlier post I can tell that the price of a long call/put with a 5 day expiry is between 85-100 pips (depending of the Fx cross). So You will have more time for the price to move in Your favour, but are paying a higher premium as well.
If anyone has suggestions for the best edge I'm listening.

Happy trading

Skoda
Can You give an example of an option trade that is just too good to pass up on and only run for a few days?
Is it something like selling a put/call just below/above a strong reversal pattern with a confluent support/resistance level?
What will the typical setup be like (long/short option, strike price and expiry), and what is Your exit plan on those trades?

Cheers
T

A word of caution about Saxo bank. If you get a margin call they will liquidate all your positions not just what is needed to satisfy your margin. This can be a big problem if you have multiple positions on at once.

No, It is EXACTLY like that! I can't give a specific example, as I haven't being taking screenshots etc as I've been going. Generally, for example, I'm looking for a long tail on a candle at 2 std deviations from the linear regression point, and only when there is STRONG support or resistance. I could just take a spot forex position but prefer to sell options in case I get it wrong.

On these trades I tend to aim for a dollar target which corresponds to a level of support or resistance. If there is only about a month to go until expiry, often the option price will drop so fast that the sold option becomes practically worthless in a few days - when that happens I will close it out, rather than hanging on for another 20 or so days for the sake of another 10 pips.

Sorry I'm so vague about the whole thing. It is very discretionary - which annoys me no end, as I am a fan of EA's and programming but can't nail it for options trading - especially since Ikon don't have an API.

Thanks Tomas,

Its alot more clearer now, thanks. I guess you are not using these types of options brok.er www.startoptions.com and www.traderxp.com where you either win or dont but do not get more pips added?

In your example, what happens if at time of expiry the price sort of stays where it is? Is it loose on both that way?

Are there any brokers without expiry time?

Thanks again,

Thanks Skoda

It gives me a pretty good idea of what to look for. But I guess that it won't be too time consuming to update support/resistance/fib/std.dev. levels and looking at price action on the most interesting pairs looking at daily or 4H price data.
Doing that once or twice a day should keep You updated to interesting trades.

I'll set up a demo account with Ikon. I got the impression that You can enter limit orders on option trades with them. In that way You can make sure that You don't sell Your options too cheap. However it might be difficult to estimate the effect on volatility on the option price.

www.fxoptions.com seems to be a nice resource for the technical analysis. The website is promoting exchange traded FxOptions, but the information You can applies to OTC fx options as well. They have volatility charts, which I can't access on Saxo Trader.

When I get everything set up and I have a live account running with a broker with lower spreads I'll be happy to share trading ideas and potential setups with You and other here on FF.

Happy trading
Tomas

Hello again

No, I'm talking about FxOptions like they're traded at Ikon or Saxo Bank. They are European style options that have the same nature like stock options but are traded over-the-counter (OTC) with a spot forex pair as the underlying security.
There are many resources on the internet where You can read about option theory in general which to a great extend is applicable to FxOptions as well.
Check out the webinars on www.ise.com under the tab education. Check out out www.optionsuniversity.com and www.theoptionclub.com.
Read this article about time decay and option pricing as well. It has a good explanation to one of the major components of the option price which is TIME. http://www.trading-plan.com/options_time_decay.html

It is in the nature of an option to have an expiry date, and the longer the expiry the more You pay for the premium, so You need a really big account if You want to buy a 3 month option to sell it one month later. The return on the total value of Your account may not even be significant if You have to buy options with that long expiry.
If You are selling options however You can roll the options. Scattergood is giving a good explanation to how this works in his thread. http://www.forexfactory.com/showthread.php?t=194796
Make sure to read the thread a couple of times to make sure You understand how it works.

And to my example:
If I sell a spot at 1.3300 and buy a call with a strike at 1.3300. The price for the long call in that case was 50 pips.
The profit scenario is as follows if I hold on to the two opposite positions until expiry:

- at any price at or above 1.3300 I have lost 50 pips, which was the price for the option premium. I am still short on the spot position, and at expiry the option automatically gets converted to a long spot position at 1.3300. If price at the time of expiry has moved to 1.3500 the long spot shows a 200 pip profit from the strike price at 1.3300, but the short spot position is showing a 200 pip loss. So the two positions zeroes out at any price above 1.3300.
But remember that I have still lost the premium of 50 pips which will be my maximum loss in this trade.

- at any price below 1.3300 the option expires worthless, but the spot position is in profit (remember that unless You close the spot position at option expiry, then You have to protect the spot with a stop-loss, since the option is no longer protecting You).
If price is 1.3270 at expiry You have lost 20 pips (30 pip profit on the spot minus 50 pip premium paid on the option).
If price is 1.3250 at expiry You are break even on the trade (50 pip profit - 50 pip premium paid), and at any price below 1.3250 at expiry You are in profit in the overall trade.

Happy trading - and studying
T

Thanks for the heads up.
I've been using Saxo Bank until now and haven't had any margin calls. I guess that I've been a bit cautious. I don't think that any broker will hesitate to close any clients positions if the get close to a margin call.

The biggest problem with Saxo is that they're quite expensive (definitely not cheap) on any of their products. The spreads on spot forex are easily found cheaper, and their commissions on CFD's and so on are quite steep as well.

I've kept a small account for trading FxOptions, but will be checking out Ikon in the near future to save on the spreads.

It is very easy to control the risk in strategy I'm referring to in this thread, since You only potential loss is what You're paying up front to purchase the option. The rest of the trade is risk free and shouldn't induce any margin calls.

There are a number of spot / options combo trades that make for some interesting trading pairs:

1) Covered Call == Buy Spot / Sell Call

Buy EURUSD @ 1.3300 / Sell 30 Day Call 1.3300 strike with 100 pip premium.

If EURUSD > 1.3300 at expiry you net 100 pips.
If EURUSD < 1.3300 at expiry you net 100 pips - (1.3300 - Price at expiry)

A covered call basically caps your profit at 100 pips, and offsets any loss on the spot market by 100 pips.

2) Covered Put == Sell Spot / Sell Put

Sell EURUSD @ 1.3300 / Sell 30 Day Put 1.3300 strike with 100 pip premium.

If EURUSD < 1.3300 at expiry you net 100 pips.
If EURUSD > 1.3300 at expiry you net 100 pips - (Price at expiry - 1.3300)

A covered put basically caps your profit at 100 pips, and offsets any loss on the spot market by 100 pips.

3) Married Put == Buy Spot / Buy Put

Buy EURUSD @ 1.3300 / Buy 30 Day Put 1.3300 strike with 100 pip premium.

If EURUSD > 1.3300 at expiry you net (Price at expiry - 1.3300) - 100 pips.
If EURUSD < 1.3300 at expiry you net -100 pips.

A married put is insurance. You can never lose more than the premium you spend, but you decrease your gain on the spot by the 100 pips you spend on the put.

4) Married Call == Sell Spot / Buy Call

Sell EURUSD @ 1.3300 / Buy 30 Day Call 1.3300 strike with 100 pip premium.

If EURUSD > 1.3300 at expiry you net - 100 pips.
If EURUSD < 1.3300 at expiry you net (1.3300 - Price at expiry) - 100 pips.

A married call is insurance. You can never lose more than the premium you spend, but you decrease your gain on the spot by the 100 pips you spend on the call.

I am happy to go through the math and detail how the profit combos actually work, but this is one of the things that makes options great. You can offset losses, ensure gains, etc. That can make your trading MUCH better.

Another strategy is to get paid for entering EVERY position you would enter anyway. For example, if you want to go long the EURUSD if it moved from 1.3200 to 1.3100, the sell the put at 1.3100 for 1 week (or whatever time you wanted) for 42 pips (currently quoted at Saxo).

If the price is below 1.3100 at expiry you get the position you wanted, but are up 42 pips. If it doesn't expire below 1.31, you just keep the 42 pips.

There are tons of strategies, and I would be happy to answer whatever questions people may have.

Are these options traded 24/7?

I have traded options a fair bit using Thinkorswim, they have some FX options but they are only traded during US Market hours. I think they are ISE options eg YUK (USD/JPY).

OTM

Hi Scattergood

Thanks for your valuable inputs.
Do You have a spreadsheet at hand where You do all the calculations for different buy/sell scenarios, or do You just compare prices on the option chain on the trading platform?
What I'm looking for is a spreadsheet that would give a qualified estimate for the option price relative to expiry date and and present spot price.
I guess all the inputs You need to enter for different scenarios is volatility, time to expiry, strike price an spot price?

Selection of the expiry date is detrimental to the success of a married put/married call strategy.

Cheers
T

Hi OTM

The FxOptions on Ikon and Saxo Bank are traded 24/5, and I'm pretty sure that the margin calculations are in Your favor on the forex trading platforms compared to the ISE options traded through a stock/option broker. Scattergood has explained the margin calculations and leverage possible somewhere in this thread or in his Strangle thread.

Cheers
T

Hello
This is very interesting because you get huge leverage compared to Equity + Exchange traded options.

I explored these ideas, Covered Call or Protected PUT using OTC FX options on Saxo white label

With Saxo however couple of questions arise

1 - Will Saxo recognise that your position is CC or Protected Put and cross margin? If you do this in Equity then CC or PP is a recognized Combo order and double margin is not required

2) Using Saxo FX options means only one market maker! so you are the mercy if Saxo!

So can this be done in some other way?

Here is another idea
A) Use Exchange traded FX ETF like FXA/ FXB, FXY etc by rydex and do tahe same as the ETF shares have Exchange traded options on the same
Downside , Leverage only 1:1, Options may not be liquid!

B) Use ISE FX option but what would be the underlying? is it FX futures? if so Would a broker recognize CC/ PP and cross margin

Any other ideas?

Limit orders only work from a buyer's perspective. I tried to set limit orders in case sold positions went against me and I wanted to close the position, but it kept telling me that the price was already greater than the limit price I was attempting to set.

Late last week I opened my 4 positions for January expiry. Both using my preferred strategy of the sold strangle. I haven't kept any money aside for any extra discretionary trades this time. On Friday both USDCAD & GBPUSD hit their linear regression points, and as there was still 40 days until expiry the premiums were high enough for me to be able to sell above and below at 3 standard deviations. Since then the price of the sold strangles has already dropped by 10 pips on one strangle & 15 pips on the other. That's another little tip, if you sell on a Friday you'll get a bonus 2 days working in your favour straight off the bat. Note that in both cases the premium received for one leg was not exactly equal to the other leg (so, it's not perfectly balanced, weighted more to one side than the other), but close enough to cancel out a fair bit of margin requirement. All going well I should not have to look at a chart for another month now.

I only use a daily timeframe. To keep an eye on the prices and still allow me to lead a normal life I use a free mobile alert service. www.mobile4x.com

Hear is a list of my current open positions if you look under the short positions of the pdf file.

nice one,profits are running