Forex Options
by Boris Schlossberg
Article Contributed by Active Trader Magazine
Most “vanilla” options strategies involve simultaneously buying and selling put and call options at different strike prices and sometimes different expiration months. Although the permutations are virtually endless, ultimately all option trades fall into two categories: high-volatility (extensive price movement) or low-volatility (little price movement).
Options can be used to trade directional moves, but it is their ability to earn profits from bets on volatility rather than just direction that makes them unique instruments. The forex market takes these special properties further and simplifies the trader’s ability to trade volatility through a set of specific “exotic” options.
Until recently, exotics have only been available to large corporate and institutional accounts, but now retail accounts can trade these products as well.
Exotic details
Unlike plain vanilla options with single strike prices and standard expiration dates (e.g., an IBM 100 call option expiring the third Friday in July), exotic options incorporate conditional scenarios regarding both price and time. The most common forex exotics are: one-touch, no-touch, double one-touch (also known as a “barrier” option), and digital options.
Exotic options are always priced as percent of “payout,” which is calculated in increments of $100 per option if the trade turns out to be correct — i.e., if the currency reaches the designated strike price. For example, if the price of a certain exotic option is 30 percent of payout, the option buyer would pay $30 for the option and receive $100 if the currency pair reached the priced designated in the option’s terms. Analyzing the different exotic options will illustrate the payout process.
One-touch options
As one of the most popular exotics, the one-touch option is profitable if the price of the currency pair touches a specified price within a certain period of time.
Let’s say the Euro/U.S. dollar pair (EUR/USD) is trading at 1.2900. A trader could buy a 1.3000 one-touch option expiring in two days for 45 percent of payout. In this case a trader would pay $45 and if price reached 1.3000 he would receive $100, or a 122-percent return on his trade ($100 payout - $45 premium = $55; $55/$45= 122 percent).
Timing is especially critical with exotic options. You must know the exact time of expiration, and each broker may have different cutoff conventions. Typically, exotic options are timed against the New York cutoff, which is 10 a.m. ET. However, some brokers will set the cutoff time at 24:00 GMT (4 a.m. ET), so confirm the time before making a trade.
One-touch options are suited for conditions when you have a strong opinion about the direction of a currency pair and you are convinced the move will happen soon. A one-touch option with a far-away target (perhaps 200 pips away) and a very short time span (24 to 48 hours) will have a very high reward-risk ratio (typically 3:1 or less) precisely because the payout on such a trade will be rare.
No-touch options
No-touch options are profitable if the price of a currency pair does not reach the target by a specified time. For example, a 10-day no-touch option of GBP/USD at 1.9200 when the pound is trading at 1.9100 may be priced at 40 percent of payout. This means you will pay $40 and receive $100 after 10 days if price does not decline to 1.9100.
A no-touch option offers better payout odds when the strike price is closer to the market price and the expiration date is farther away because the chances the currency will not touch the strike price diminish considerably the longer the trader has to wait.
One interesting property of the notouch is the fact the underlying currency pair does not have to move in the trader’s direction (that is, away from the strike price) in order to produce a profit. The currency pair simply has to stay relatively stationary in order for the trader to collect a payout.
Double one-touch
The double one-touch option allows you to select two strike-price barriers and provides a payout if either one is touched. If the Euro/U.S. dollar (EUR/USD) spot was trading at 1.3000, you could buy a double one-touch with 1.2900 and 1.3100 strikes expiring 48 hours forward. If EUR/USD either rose to 1.3100 or declined to 1.2900, you would make a profit. The double onetouch is similar to a standard long strangle or straddle option trade in that it is a good tool to use when you have no strong opinion about direction but you expect volatility to explode.
Double no-touch
The double no-touch option is the opposite of the double one-touch. It is appropriate for situations in which you anticipate a range-bound market and expect volatility to be low.
Large trend moves are often followed by periods of consolidation; the double no-touch can be a profitable trade to use in these cases. Assume the EUR/USD makes a strong up move from 1.2400 to 1.3400 over several weeks, but price then pauses and starts to weaken a bit. A trader could buy a double no-touch from 1.3200 to 1.3600 with expiration in a week. If the market remains within these boundaries, the trader will walk away with a profit.
One-touch and no-touch options are highly time sensitive. A one-touch will be significantly cheaper the less time there is to expiration because the odds of reaching the target will be greatly reduced, while a no-touch will be priced in opposite fashion because the chances of not touching the target will diminish the more time is left on the contract.
However, the double one-touch and double no-touch options will have the same pricing parameters in terms of time but will vary greatly with respect to the width of the barriers. Double one-touch options, for example, will become progressively more expensive as the barriers narrow.
Recent pricing in double one-touch options in the U.S. dollar/Japanese yen rate (USD/JPY) with 10 days to expiration and the spot rate trading at 104.75 were as follows: For strike barriers between 103.50 and 105.50 (meaning price had to hit either one of those points for the option to pay out), price was an eye-popping 95 percent of payout, offering the trader only a potential 5-percent gain against a 95 percent loss.
Expanding the boundaries to 102.50 and 106.50 reduced the premium to only 41 percent of payout. Conversely, the double no-touch options would have the exact opposite properties, offering much higher payouts as the strike prices narrowed.
Digital options
Digital options produce a payout if the spot price meets or exceeds the selected barrier price at expiration.
Let’s imagine you buy a digital option for 105.00 USD/JPY that expires 10 days forward when spot is trading at 104.00. In the next nine days, USD/JPY may be trading comfortably above the 105.00 barrier between 105.50 and 105.90. However, if on expiration day USD/JPY slips below 105.00 and ends the day at 104.99, the trader would forfeit the entire premium.
Accordingly, digital options are less expensive than one-touch options with the same strike and expiration date. Digital premiums can be half the price of no-touch options premiums with the exact same strike price and expiration dates, but the trader has to weigh the advantage of lower cost against the risk price will settle even 1 pip below the target at expiration.
In certain respects digital options resemble the vertical spread in vanilla options, where the trader buys a put or a call and offsets it by selling a cheaper put or call a strike higher/lower. In that scenario, the maximum payout to the trader would be the difference between the strike prices minus the premium paid. The key difference is digital options will pay maximum payout as long as the target level is met or exceeded, while the vertical spread will only pay out the maximum return if price exceeds the outer strike zone. The vertical spread will pay out partially if price settles somewhere between the two strike prices.
Exotic options and trading news events
Although forex is the largest and most liquid market in the world, during certain news announcements it can become extremely volatile, as dealers try to adjust to new information and millions of traders attempt to enter or exit the market at the same time. Dealers often widen their spreads and trade execution can become problematic. Spot traders who are often trading highly leveraged positions expose themselves to tremendous slippage and potentially devastating losses if they are on the wrong side of the market. It is during this time that exotic options can be especially useful instruments.
The release of U.S. Non-Farm Payroll report at 8:30 a.m. ET on the first Friday of every month presents a notoriously difficult environment to trade — the EUR/USD will often rise or fall more than 100 points in a manner of seconds. While this can be a maddening time for spot traders, option traders can profit handsomely.
Because exotic forex options predetermine entry and exit points ahead of time, buyers of a one-touch option don’t need to worry about entering the market as liquidity suddenly disappears and many brokers widen their spreads to five times their usual size. Nor do they need to worry about slippage on stops if their positions are wrong. They know if their analysis is correct and the currency pair trades through their price, they will profit; if they are wrong their risk is limited to the cost of premium.
The spot trader enjoys no such assurances. During these volatile times orders often slip hundreds of pips as dealers try to cope with order imbalances. Furthermore, because volume often spikes to 10 times the normal level, simply accessing dealable quotes can be difficult. Some dealers provide phone access, while others only offer electronic order entry. Regardless of individual dealing practices, the process is rife with danger, especially for heavily leveraged traders. That’s why news events such as Non-Farm Payroll numbers, Central Bank rate announcements, current account reports, and inflation data can be traded with more flexibility and far better risk control using exotic options rather than spot.
Preparation
Of course, you cannot simply pull up your trading screen five minutes before an event and expect to obtain a reasonable price on an exotic option. At that point volatility is likely to have increased to such an extent that most trades will be unattractive from reward/risk point of view. However, traders who do their analysis and plan trades a week in advance of an event will be in a much better position to find favorable opportunities.
The operative word here is plan. Planning may be the greatest benefit of option trading. By sifting through possible scenarios and analyzing the probabilities of each trade strategy, the option trader engages in a far more rigorous intellectual process than the reactive spot trader. And we all know impulse trades often generate the worst losses. “Have a hunch – bet a bunch” may be fine for a few harmless dollars on lottery tickets, but it is not a good strategy for trading success.
Boris Schlossberg is Senior Currency Strategist at FXCM. This article was originally published in the June 2005 Edition of Active Trader Magazine