Steve Meizinger
Developing an FX
Trading Strategy
Steve Meizinger
www.ise.com
[email protected]
For the sake of simplicity, the examples that follow do not take into
consideration commissions and other transaction fees, tax considerations, or
margin requirements, which are factors that may significantly affect the
economic consequences of a given strategy. An investor should review
transaction costs, margin requirements and tax considerations with a broker
and tax advisor before entering
into any options strategy.
Options involve risk and are not suitable for everyone. Prior to buying or
selling an option, a person must receive a copy of CHARACTERISTICS AND
RISKS OF STANDARDIZED OPTIONS. Copies have been provided for you
today and may be obtained from your broker, one of the exchanges or The
Options Clearing Corporation. A prospectus, which discusses the role of The
Options Clearing Corporation, is also available, without charge, upon request
at 1-888-OPTIONS or www.888options.com.
Any strategies discussed, including examples using actual securities
price data, are strictly for illustrative and educational purposes and are not to
be construed as an endorsement, recommendation or solicitation to buy or sell
securities.
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Options give you alternatives
• Options allow for the transferal of risk from those
investors that would like to reduce risk to those who
would willing to increase risk.
• Efficient markets assume risk and reward are
inherently linked. If investors desire higher rates of
return they normally will have to take more risk to
achieve the higher rates of return.
• Options values are based on the risk appetite of
investors and the cost of money.
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Foreign Currency explained
• Foreign currency markets allow investors to
implement strategies based on their own forecasts of
the currency markets.
• When trading foreign currencies, an investor buys one
currency and sells another, that relationship is called
a currency pair.
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For more foreign exchange education
www.fxte.com/
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ISE FX pairs
• All pairs are dollar based- The base currency is the
US dollar, using this convention when trading options
an investor could simply buy call options if they are
bullish on the US dollar and buy put options if they are
bearish on the US dollar.
• There are many other strategies that can be
implemented when trading ISE FX Options, straight
call and put buying are the most basic strategies.
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Four currency option pairs are currently trading at ISE
• US dollar/Japanese yen YUK
• US dollar/Canadian dollar CDD
• US dollar/Euro EUI
• US dollar/British pound BPX
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Creating a Trading Plan for ISE FX options
• Learn as much as possible about the basics of
options.
• Understand risk and reward and how that concept
relates to options and formulate that into your trading
plan.
• Select a trading style that you are comfortable with
based on your goals and risk tolerances.
• Learn more about the foreign exchange market to be
better positioned to make timely forecasts of the
currency pairs.
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Creating a Trading Plan for ISE FX options
• Study the various currency relationships and choose
the pair that best suits your trading forecast and
trading personality.
• Establish more refined expectations by learning more
about the options “Greeks.”
• Actively manage your trades, although FX markets
may display lower volatility than equity options and
even equity index options.
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Which pair to trade?
• A recent study revealed that 90% of all FX trading involved the
US dollar (currently all ISE FX option pairs involve the U.S
dollar).
• Investors can select among the differing pairs based on their
views.
• An investor that is bullish on the US dollar normally would pair
that view with the currency they felt would be weakest to achieve
the best potential results.
• An investor that is bearish on the US dollar normally would pair
that view with the currency they felt would be the strongest to
achieve the best potential results.
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How do you select the “other” currency?
• Markets will normally concentrate on certain “themes”,
investors should learn as much as they can about
those “themes.”
• Some examples of recent “themes”
– Canada- Commodities driven
– Japan- Slower international growth, risk aversion
– Euro-region- Balanced growth with some risk aversion
– UK- Highest risk-free rates relative to US and Canadian
dollar, yen and euro
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“Pips”
• In the spot forex market a “pip” is the smallest unit of price that is
traded for a currency. Most currencies are traded to four decimal
points, so that a pip is 0.0001 or 1/100 of a cent.
– Using ISE FX options the exchange rate value is multiplied by 100
to create the value the options trading underlying value. Therefore
one “pip” would equate to .01
• The exception to the four decimal points is the Japanese yen
which is normally traded to two decimal points.
– Using ISE FX Options, when trading US dollar/yen, the exchange
rate is multiplied by 1 to create the options trading underlying value.
Therefore one “pip” would also equate to .01
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“Themes” change though
• Be careful as these “themes” can change (others
might call these “themes” correlations).
• Investors will want to consider their own time frame
selections and also whether they like to trade with
trends, against trends or using some other
methodology.
• Whatever methodology an investor uses, an
alternative exit strategy may be appropriate to limit
your losses and take profits at the correct times.
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Views on FX can be implemented at ISE
• Using ISE cash settled FX options your views on FX
can be easily implemented through the using of many
of the familiar options strategies.
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Initial ISE FX Offerings (September 24)
• USD/EUR (ticker symbol, EUI) 71.08
(0.7108 x 100)
• USD/GBP (ticker symbol, BPX) 49.64
(0.4964 x 100)
• USD/JPY (ticker symbol, YUK) 114.74
(114.74 x 1) the rate modifier is 1 for JPY
• USD/CAD (ticker symbol, CDD) 100.45
(1.00.45 x 100)
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Balance of Risk and Return and Forecasting
• Markets move due to fear, greed, hope and despair.
• Your trading methodology is important. Investors
should consider their own financial goals and their
own risk tolerances when considering their
methodology.
• The essence of foreign exchange options investing is
forecasting how far an asset will move, up or down,
and in what time frame. The volatility component is
important when entering and exiting trades. Interest
rate differentials are also very important in foreign
currency pairs.
• Investor forecasts are the foundation of all options
strategies.
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Markets move for various reasons
• Interest rates in either or both countries, or the so
called interest rate differentials.
• Macro economic government reports such as
industrial production, capital spending and
employment.
• Consumer confidence surveys.
• Growth of the respective countries’ economies
• Amount of debt of the respective countries
economies.
• Unexpected “shocks” to the economies.
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Three important factors for FX
• Productivity- How much time (labor hours) does it take to
produce output? The less time it takes the better for the economy
• International Investment flows- If investors (either locals or
foreigners) are confident in the future economy, capital will
normally fund investments creating future growth.
• Interest rates- Interest rates combine productivity and
investment flows to price the cost of money. The interest rates
are a primary factor in the pricing of currencies.
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Trading Psychology
• Gaining confidence, but not over-confidence, this is a
difficult balance.
• Trade in your comfort zone (not anyone else’s).
• Assume all your trades will not be necessarily right,
understand what to do if things go wrong. Consider
the phrase “the return on your money vs. the return of
your money.”
• Markets are like soap operas, they continue forever
with similar themes, but prices may occasionally
move in an unexpected fashion, sometimes quickly.
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Trading Style
• Style will be based on your financial goals.
• Investing in options based on foreign currencies give
investors many choices. The pair selection should be
based on your own view of the respective countries.
• Some choices for the time frame are: position (longer-
term), swing (intermediate) and intraday (short-term).
• Your style will help form your trading methodology,
whether it is buying calls or puts, option spreads, or
any other options strategy.
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Time frame for trades for FX options
• Position- Normally, as short-term as a few weeks to
as long-term as a few years.
• Swing- Can be any period longer than a day but less
than a few weeks.
• Intraday- Trades that are closed out that same day,
this may be very challenging due to the lower volatility
of the pairs relative to equities.
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Which time frame is appropriate for you?
• This is dependent on what time frame you are most
comfortable forecasting.
• Many investors feel more comfortable with position
trades, some feel more comfortable with swing trades.
• Using ISE FX options investors can implement their
longer term views of the FX markets without the
concerns of the intra-day stop-loss order concerns.
• An investor should trade in the period that they are
most comfortable in forecasting based on their own
goals and their own risk tolerances.
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Each investor must determine what information is vital for them
• Interest rate differentials are important when considering foreign
exchange markets and FX options.
• Investors must weigh the interest differentials relative to the
actual future growth rates of the respective economies.
• If an investor believes that a certain currency pair has a relatively
wide interest rate spread and they believe the economy with the
higher interest rates will continue to “outgrow” the other country
the investor may want to implement a complementary options
strategy.
• Or, if an investor believes that a certain currency pair has a
relatively narrow spread and the investor believes that one of the
countries will sustain much higher growth in the future, the
investor may want to implement a complementary options
strategy.
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Risk and Reward
• Once you determine your acceptable risk and reward
balance, and how you view the markets you can
select the appropriate currency pair to trade and the
time horizon that is suitable for your personality.
• When trading options an investor must consider how
far they expect the exchange rate to move, how long
will it take for the rate to move, and also the potential
for implied volatility change.
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Simple but sometimes very effective
• Long call- If an investor feels the US dollar will rally
strongly, this may be a viable strategy.
• Long put- If an investor feels the US dollar will
weaken significantly, this may be a viable strategy.
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And a couple of more moderate strategies
• Long lower strike call, short higher strike call = Long
vertical call spread (bullish on US dollar)
• Short higher strike put, long lower strike put = Short
vertical put spread (bullish on US dollar)
• Long higher strike put short lower strike put = Long
vertical put spread (bearish on the US dollar)
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And a couple of more moderate strategies
• Short lower strike call, long higher strike call= Short
vertical call spread (bearish on the US dollar)
• Buy two out of the money puts against one at the
money call= Synthetic long straddle (long FX volatility)
• Sell out of the money call spread and out of the
money put spread= Iron Condor. This position
creates a short FX volatility position with limited risk.
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Options strategies should be personalized
• Never trade options strategies that you do not fully
understand.
• Never trade options strategies that are not compatible
with your own individual risk reward tradeoffs.
• Trade in your comfort zone not someone else’s.
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These strategies may look similar, but??
• Understanding the basic strategies will enable option
investors to grasp the advantages and disadvantages
of the more complex options strategies.
• Risk and reward are inherently linked, even though
selling options looks attractive, be careful...
• Remember the term “unlikely” does not mean
“impossible.”
• This year we have already seen some unlikely events
occur, trade within your own goals and your risk
tolerances.
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Option Trading Levels
• The trading levels are determined by each individual
broker. Being approved for the higher trading levels
does not require that investors implement those more
complex strategies immediately, or ever.
• Approval gives investors increased flexibility if the
investor chooses to implement those more complex
strategies.
• An investor should not trade outside their own comfort
level, carefully balancing their own risk tolerances and
their own financial goals.
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Implementing your forecast using options
• Have a forecast, implement a complementary options
strategy
• What period of time will you require for your forecast
to come true, considering the risk and reward of the
trade?
• Predetermine your entry point at price you deem
attractive.
• Predetermine your “pain threshold” or “tilt number”,
taking into account the possibility of potential opening
market gaps.
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Implementing your forecast
• Predetermine your goal for the trade.
• What are the best and worst case scenarios? Delta, gamma,
vega, theta and rho may be helpful “risk gauges.”
• What happens to my trade if the underlying pair doesn’t move in
the time frame, or doesn’t move far enough or the volatility
changes dramatically?
• Enter the market at your appropriate predetermined price.
• Continue to monitor your pain threshold.
• Make adjustments as necessary, either due to your “pain
threshold” or due to your profit objectives.
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“Tilt number”, what should that be?
• Your “pain threshold” by definition is your maximum
risk number, not someone else’s. Remember, the
market can move against you as easily as it can move
for you.
• Your pain threshold should be a small percentage of
your overall options portfolio. The goal is to have
enough staying power to carry you through periods of
poor performance. The actual amount is entirely up to
each investor.
• One other consideration; if the FX options investment
is a hedge, will you hold it until the end of the option’s
life.
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Active Management
• The goal is to try to let your profitable trades grow and
cut your loses on your losing trades.
• Think of this, if you lose 50% of your assets on any
one trade you need to achieve roughly a 100% rate of
return on your remaining assets just to break even.
Managing trades that move against an investor are
also important.
• “The portfolio approach”- How much capital am I
willing to use as risk capital. Or, how much capital do
I wish to hedge?
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Active Management
• Long options do have embedded “stop-loss” amounts, but they
carry time-decay risk (theta risk)
• If the options are priced reasonably high and have higher deltas
maybe active management is needed investors should consider
the delta risk
• Understanding the option greeks are helpful:
– Theta
– Delta
– Gamma
– Vega
– Rho
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Active Management
• Short options do not have an embedded “stop-loss”
amounts, naked short options (gamma risk) may be
only for the most experienced investors. Ask your
broker if you qualify based on your risk tolerances and
the capital held at the broker. Not only should your
trading experience and capital qualifications be
considered, but your own trading personality and
attitude toward risk aversion.
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Active Management
• When implementing long call and put strategies, one
method for managing profitable positions might be the
use of spreads, if you are approved for spread
trading. Spreads can help reduce risk with more
moderate potential payoffs.
• In lieu of outright selling profitable positions, one
strategy is to hedge them by selling the upside call
against a profitable call or a downside put against a
profitable put.
• The use of the credit spread strategy is an attempt to
profit from selling options with a pre-defined limited
risk. The risk will vary in each instance, depending on
how wide apart the strikes are from each other.
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Active Management
• When managing option positions that have gone
awry, the use of stop-loss orders may be
recommended. Of course, there are some
disadvantages of the stop-loss option order, if the
market rebounds after your stop-loss order is elected
you will not participate in your original market
forecast.
• Just remember FX volatilities are low but the currency
pairs may still move, although the amount should be
much less than comparable equity options or even
equity index options.
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Cars have caution gauges, options have Greeks
• The Greeks can help investors “detect” when
situations might be getting riskier.
• FX pair volatility (vega risk) and the respective
countries interest rates are the two important
parameters for foreign currency options pricing.
• The interest rate differential is an important pricing
input for foreign currency options. (Rho risk)
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Options Greeks can help form expectations
• Delta- How much the options price moves in price
given a unit change in the underlying exchange rate.
• Theta- How much the option depreciates or “decays,”
normally measured on a daily basis.
• Gamma- The amount the delta of an option changes
given a unit change in the underlying.
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Option Greeks
• Vega- How much an option gains or loses given a unit
change in the volatility.
• Rho- How much an option gains or loses given a one
percent change in risk-free interest rate differential.
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Delta
• Calls have positive delta, puts have negative delta.
• Deep-in-the-money options have high deltas, near
100, and deep out-of-the-money options have low
deltas near 0.
• At-the-money options calls and puts have deltas with
an approximate delta of 50 or an equivalent of 50% of
the underlying value.
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Theta
• Options are worth 0 or intrinsic value at expiration.
• The loss of the extrinsic value is also called time
decay.
• Short options have positive decay, long options
negative decay.
• Greatest ATM due to the highest amount of extrinsic
value for ATM options.
• ITM vertical spreads benefit from positive decay.
• OTM vertical spreads suffer from negative decay.
• Options do not decay in a linear basis, shorter term
options have greater theta relative to longer term
options.
• Higher theta results in more gamma.
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Gamma
• Gamma “manufactures” delta, long options delta
increases as it moves toward the strike price and
eventually “ITM”
• Gamma is highest at the strike price just prior to
expiration
• Options far “ITM” and “OTM” have low gamma
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Vega
• ATM options with the most time left until expiration are
most sensitive to nominal change in vega.
• OTM options are the most sensitive on a percentage
basis.
• Some market professionals believe that predicting
future volatility is just as difficult as predicting the
future asset price.
• Shorter-term options have less vega relative to
longer-term options, but have more theta.
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Rho for ISE dollar based FX options
• Measures the interest rate differential cost of holding
a position.
• An FX option with a positive Rho will increase in value
for each percentage point increase in interest rates
• Long calls and short puts have negative rho (a
decrease of the US interest rates increases the
theoretical value of the US relative FX pair in the
future).
• Short calls and long puts have positive rho (an
increase of US interest rates decreases the
theoretical value of the US relative FX pair in the
future).
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Greeks, who cares?
• Investment decisions begin with your forecasts. FX
investment decisions are no different. Your own
financial goals and risk tolerances will shape your
decision making.
• Understanding the risk and reward of the various
option strategies and how the differing risk
parameters can affect the profitability of each are of
vital importance.
• Consider what can go wrong, not just one can go
right.. The greeks can help approximate the risks
involved with some unexpected events.
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A word of caution about pricing models
• The strength or the weakness of any option pricing
model is the assumptions used, be careful of the
assumptions.
• In order to use a basic option pricing model, investors
will need to have the correct risk-free interest rates in
both countries.
• Using ISE FX options the dollar is the base currency
for all pairs.
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Models have flaws but they help build investor expectations
• In most cases the option pricing model reflects the
known risk-reward of each trade
• Occasionally circumstances change, investors should
be aware that the model may not be 100% accurate
all the time.
• Most importantly the option pricing model “Greeks”
are similar to gauges in a car, helping warn you when
something may be wrong.
• But these models are not 100% accurate either, they
should be used along with other tools.
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Greeks, who cares?
• By using an option pricing model and “stress-testing”
your strategies you may be able to better understand
how the pricing parameters affect your trade.
• Adjusting the FX pair value, volatility used and the
days left until expiration and the respective pair’s
interest rates give you a glimpse of what can go
wrong.
• Remember, options are about magnitude, timing, and
what will the volatility be when I exit my trade?
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Actively managing your trades
• Goal is to actively manage your trades, both winners
and losers.
• One idea is to use either percentage or standard
deviation using volatility.
• Carefully monitor delta, gamma, theta, vega and rho
to manage risk.
• The objective is to maximize profits and minimize
losses.
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No Single easy answer
• Investors must make some type of forecast.
• Will the underlying be higher, lower or stay in a
range?
• What time frame am I comfortable with forecasting?
• How far can the asset move (reasonably)?
• Why will I change my forecast?
• What will I do?
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Should I stay or should I go..
• If your original forecast is wrong, maybe it is
best to close out the position and start over.
• If I did not have a position would I want a
position, or would I prefer a more “hedged”
position.
• Risk and reward must be considered along
with your own forecast for the underlying
instrument.
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Adjustments
• The future FX pair value, timing and volatility will
ultimately impact the economics of the trade. The
correct interest rate differential is also very important
when trading foreign exchange options.
• Adjustments do not “guarantee” turning a losing trade
into a winning trade though.
• There are a myriad of alternatives to consider if you
feel an adjustment is warranted rather than exiting the
position.
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Risk vs. Reward
• Investors must consider “what if” scenarios prior to
adjustments and balance the risk and reward to
determine if the adjustments make sense to you.
• Investors must try to remember that sometimes the
simplest way to cut a loss may be the best, close the
position. If however, you feel that adjusting the
position gives you a better risk reward position then
the adjustment may be warranted.
• Sometimes the easiest way to rectify a poor trade is to
close it out and start new with another strategy or
another trading instrument.
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Options knowledge is good
• A thorough understanding of option synthetics will
further help your assessment of the required
adjustments.
• The option risk gauges (Greeks) also helps to assess
risk.
• Hedging delta, gamma, theta, vega and rho may be
required.
• Spread trading is one options strategy that can often
reduce the “Greek” risk.
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Summary of Developing a Trading Strategy
• Learn to manage your expectations by learning more
about the options “Greeks.”
• Understand risk and reward and how that concept
relates to options and formulate that into your trading
plan.
• Learn more about FX options market, it should help
you better comprehend the ebbs and flows of the
other markets.
• Select a trading style that you are comfortable with,
based on your goals and risk tolerances.
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Summary of Developing a Trading Strategy
• Trading with confidence, yet not over-confidence is
the goal.
• Creating your comprehensive trading plan is normally
the sum of your forecast for the FX pair, options
knowledge, risk reward tradeoffs, managing your
expectations and actively managing your trades.
• Never trade beyond your comfort zone risk
tolerances. Remember, FX markets as well as other
markets can sometimes move in unexpected ways.
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Commonly asked questions regarding ISE FX Options
• Can I get price charts? Yes, Bigcharts.com has all of the ISE
traded pairs available as well as the option chains
• Do the “greeks” work for FX options pricing? Yes, if an investor
inputs the correct interest rate and dividend yield (US risk-free
rate) option calculators will work, and of course the volatility
• How much do these options cost? Same as equity options,
$1.50 options costs $150
• How does the term “pips” relate to ISE FX Options. Roughly
speaking 100 pips equals 1 ISE point
• What does dollar relative mean? The base currency is the US
dollar, if the US dollar increases relative to the foreign currency
the value of the pair increases, if the dollar decreases the value
of the pair decreases
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Steve Meizinger
www.ise.com
Educational Webinars offered
Tuesdays at 4:00 EST
For more foreign exchange education
www.fxte.com/
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Steve Meizinger
Developing an FX
Trading Strategy
