The CME made this decision because the professional community of traders directly trade volatility. Spot Delta This Greek term relates to how much the option price changes in response a change in the underlying spot forex prices. It is the most important of the Greeks and there are many delta-related trading strategies the trader can become familiar with, which will be discussed in a later chapter. The trader will primarily look at delta to help identify the ability of the option premium to move.
A high delta means that the option premium will track more closely the move of the underlying spot currency. Delta ranges from 0. Calls have a positive delta, and puts have a negative delta. An option call or put with a 1. When an option is ATM or at the money, the delta is at 0. This means that the option premium price will move 50 percent of the movement of the underlying currency pair. While deep-out-of-the-money options may be cheap, they are cheap for reason! For example, if a currency option is ITM, its delta may move closer to 1 as it approaches expiration, and deltas of OTM options would approach 0 as expiration came due.
For those who are technically oriented, there are also forward delta and driftless delta measurements. When the premiums of calls and puts with the same delta are not equal, the forex trader needs to be alerted to a skewing of the market sentiment. This should be taken into consideration on developing trading strategies.
In the center is the ATM strike price. The 25 delta strike price for the put is The ATM is The volatility for the put is At this moment in time, the market shows more volatility for a downward direction but is still pricing calls more than puts, which shows market sentiment favoring the calls. It is important to note that this skew is not a prediction of direction. Note that both options have the same expiration date of March 28, But that is not always the case. When the premium price does not go up, the forex trader confronts the phenomenon of a decline in implied volatility.
Here is an example where the premium price hardly moves up!. The volatility of the first strike price is Practice this exercise over and over. In this book, we concentrate only on options strategies that have predetermined and limited risk.
This includes writing an option when it is part of a spread or combined with a covered position such as an underlying spot position. However, we are not discussing writing options as an isolated strategy. In this chapter, the reader learned about key elements of an option trade and how those elements are reflected in the nomenclature of the forex market.
The reader also learned about how those elements provide clues to market sentiment. A key concept is comparing call option premium prices with put option premium prices to detect which way the sentiment is skewing. Now that we have covered the essential components of forex option trades, we can move to the task of developing trading ideas. But the most important ones are time and volatility. In forex option trading, the factor of time is ticking away at the orig- inal option trade.
Known as theta, time can be an enemy or a friend. To buyers of an option it can be an enemy, because the longer it takes to maturity, the more things can go wrong and the option trade can either run out of time and never become profitable or, if it was profitable, can have time to reverse into losses. However, the longer it takes to get to maturity, the more time the trader has to be right in his direction.
Often, prices have retracements, try to reverse, but turn around. More time may allow the trade to work out. But to sellers of an option, time is a great friend. In Figures 2. Notice how the premium price changed. The premium price went up from to as the time to expiration changed from 22 days to 53 days. American-style options allow for exercise at any time. This increases the uncertainty to the market, and therefore American style options usually are more expensive. Understanding volatility, even for the beginning forex option trader, is essential.
When the weather is volatile, there are storms; when nations conflict with each other, the highest level of volatility is war. In trading, volatility is a mathematical concept that deals with the deviation of prices. The change in prices over time is how volatility is measured. Technically, volatility is the annualized standard deviation of the log-returns.
However, we are not concentrating here on the mathematics of volatility but on how it can be used by the forex trader and how it should be understood. The at-the-money ATM volatility is 9. We can see in Figure 2. We know that the premium price reflects many variables and that volatility is a key component.
This is because the market sees more risk, and therefore the option premium costs more. Notice that this is exactly what happened. A change in volatility from 9. What would happen if volatility decreased? Generally in the industry, volatility data is supplied by global financial data firms such as Tullet and Prebon, Superderivatives. Why Volatility Matters If there were no uncertainty as to the price of a currency pair in the future, there would be no volatility at all.
Uncertainty in the market leaves a visual track and can be detected if the standard deviation of the exchange rate increases. The average forex option trader needs to know why and how volatility matters. There are several very important features for forex trading. In general, the higher the volatility, the higher the premium the market will require. This is because when there is higher volatility the probability that the option will be in the money at expiration increases.
Volatility is easy to measure historically, but it is very hard to observe in real time what the volatility is, and it is even harder to predict whether volatility will increase. This is because there are so many variables that can im- pact future volatility, and no system in the world can identify all the variables.
Therefore, the field of financial mathematics has come up with the term implied volatility because it is, in fact, only implied and is an estimate about volatility. The famous Black-Scholes equations assume a constant volatility, which is not the case at all in forex.
Financial mathematics professionals are always looking for and developing new ways to project an accurate volatility surface. One of the most useful and famous is known as the volatil- ity smile. The Volatility Smile In option trading, generally, volatility increases as the option moves away from the spot position or ATM position. The volatility smile graph a 2 or 3 2-dimensional plot of the im- plied volatility along different maturities but similar deltas.
It shows whether the market is favoring puts or calls. In Figure 2. Smiles can happen for many reasons, such as market fear of a crisis causing volatility to increase proportionally more on one side. There are important option trading implications associated with detecting a smile, which we will explore later on.
If possible, the forex option trader should access software that provides 3D volatility sur- faces. Many third-party software firms are now providing volatility surface visualizations. The 3D volatility surface has three axes; one axis has the deltas for the puts and calls, with the ATM in the middle.
The axis next to it is the maturities can be from 1 day to 10 years. The vertical axis displays the volatilities. The trader can see instantly whether the market is favoring puts or calls. For example, we can see in Figure 2. Used with permission. Now contrast this with the volatility chart for the Iceland krona in Figure 2. Notice its volatility is flat. Trading Tip: When a volatility skew is favoring calls, think about a call ratio spread.
When a volatility skew is favoring puts, think about a put backspread. Notice in Figure 2. The market sentiment for calls and puts is nearly the same. Theoretically, the premiums for the calls and puts should be the same. But if the price is greater on one side than the other, the market is said to favor that direction. The full text can be found at www.
Volatility Smiles and Becoming Cynical Traders in forex should be a bit cynical about the option prices that are offered by the forex firms, particularly if they are based on the Black-Scholes model. This is because, as noted earlier, the Black-Scholes assumes constant volatility across all strike prices for the same underlying price.
The fact is that the market produces a skew in the volatility. This is called a volatility smile. When a trader finds a volatility smile, there is a bias in the market. The trader should realize that the bias reflected in the smile reflects larger forces. Expect surprises in the underlying volatility, and this will affect probability of profits.
Volatility Smiles at the Beginning of It will be valuable for students of forex option trading to compare the volatility smiles of the currency pairs over time. Did they change? How long did they last? The purpose of this section is to give the reader a frame of reference for understanding volatility smiles. Try to answer the following questions: How long did it take for the currency pairs to move in a direction against the volatility smile bias?
What was the average time for such a reversal? Historical versus Implied Volatility The forex trader should constantly be looking for extremes in volatility. When volatility is at an extreme high or low, it contains information about market sentiment and direc- tion. It also is a signal of instability. A good place to begin to answer this question is by comparing historical volatility versus implied volatility. Historical volatility is really statistical volatility measuring the actual variation in prices over time.
When the prices widen in their range, the standard deviation rises, and this means that the historic volatil- ity will be higher. Traders use a varying time frame ranging from 1 day to 1 week to and day periods. Twenty days is a common time frame for looking at historical versus implied volatility.
Implied volatility is an expectation of the volatility that the market is anticipating for a particular option during the life of that option. The premium priced for the option reflects market sentiment about many things, and most importantly, the price reflects an implied volatility. This expectation is not perfect, and the equations generating them are not perfected.
But the implied volatility is what the market is assigning at that moment, and it must be respected. When comparing historical versus implied volatility, the trader can see if the im- plied is excessive over the historical. For example, a 1-month implied volatility chart should be matched with a 1-month historical volatility chart.
Historical versus Implied Volatility on Charts Figures 2. Look- ing at Figure 2. In forex option trading, 1-month volatility should not be the only period for evaluation. The common practice is to use a longer time frame such as 3 months. This was in contrast to the 1-month expansion of volatility.
According to the theory of re- version to the mean, the trader could conclude that the 1-month gap is exaggerated. Therefore, this leads to trades favoring a contrac- tion of the volatility. For example, if the trader thinks that historical volatility is too low and would increase, a good strategy would be to buy straddles.
A good idea is to scan the historical versus the implied volatilities of the currency pairs. The trader should look for extremes. For example, in such a scan we found that the USDCHF had a scenario where the historical volatility was excessive versus the implied volatility. We can see that this spread was the widest in over a year on the chart below. The trader would correctly anticipate a contraction of volatility. One month later, the volatility significantly contracted, as seen in Figure 2.
The trader observing that the volatility was at an extreme would look to option strategies which benefit from a loss of volatility. One such strategy is the carry trade. Benefiting from a Loss of Volatility The carry trade is an option strategy that benefits from a loss of volatility. One month implied volatility for the yen versus the dollar fell to A decline in volatility encourages carry trades as it makes the profit more predictable.
Forex option traders should frequently scan the currency pairs comparing historical versus implied volatility. The key question to ask in reviewing historical versus implied volatility is: Which of these depicted currency pairs would you trade and in what direction? Write down your reasons.
The high volatility of the USDCAD suggests that the prices are unusually high in the underlying, further suggesting a sell strategy. Forecasting Volatility Changes While implied volatility is usually compared with historical volatility, it can also be com- pared with a projection of the volatility.
A projection of volatility attempts to provide a leading indicator to the trader. There are many technical analysis firms trying to do this for institutions. For example, in Figure 2. This forecast was based on the use of implied volatility analysis. The idea behind this projection is that the data showed that the implied volatility associated with that strike price was much higher This was considered very extreme and therefore to have a high probability of returning to a lower volatility level.
Once the trader can find this kind of projection, many different option trading strategies can be for- mulated, including hedging, writing options, and the like. Of enormous importance to those trading forex options is the emergence of ETFs on cur- rencies. These provide a greater amount of analytical information than readily available at forex firms. Forex traders should track all of the key currency ETFs. For example, Figure 2. This could be used as an indication to put on a long time spread—buy ATM call in January and sell ATM call in December , for example; comparing the slope of option volatility against a forecasted slope leads to further insights about which option strategies can fit market conditions.
Here is what Myron Woods of ORATS, the options analysis firm, says about this: A high forecast slope relative to implied slope indicates that a vertical spread in- volving selling a lower strike option and buying an upper strike option looks at- tractive, from the perspective of relative valuation of the implied volatilities of the lower strike versus the upper strike. In other words, the lower strikes i.
The Volatility Cheapness Index The volatility cheapness index at Optima provides another useful way of spotting currencies that are in extreme modes of volatility. The volatility cheapness index measures how implied volatility currently compares to the last five years of history of volatility, ranked on a percentile scale ranging from zero lowest to highest. We can see in Table 2.
The Swiss franc was ranked lower, at We will identify these strategies in Part Two, but generally speaking, if volatility is expected to increase, then the option trader will look to play range-probing or range- breaking price actions. Volatility and Price Movement—Sigma Boundary Charts In order to visualize what volatility actually implies for future price movement, it is useful to view a one-standard-deviation projection of price movement out into the future.
This is called a sigma boundary chart. In order to do this, we simply take the current level of implied volatility, which is an annualized figure, and reduce it to shorter time frames, projecting the sigma boundary cone ahead from the current date.
In a normal data dis- tribution, the price movement will typically remain within plus or minus one standard deviation about two-thirds of the time, within plus or minus two standard deviations 95 percent of the time, and within plus or minus three standard deviations 99 percent of the time.
By projecting a one-standard-deviation sigma boundary cone looking ahead, we can get a visual picture of the boundaries for price movement that the market is expecting. Specifically, the options market in the implied volatility figure is forecasting a two-thirds chance that the price movement will remain within the one-standard-deviation boundary in the future. If a trader believes that the price movement is actually likely to breakout of that enve- lope, then the trader essentially believes that volatility is cheap and the trader may want to buy volatility.
By the same token, if the trader thinks the price movement will remain within the one-standard-deviation envelope, then the trader effectively thinks volatility is expensive and may want to sell volatility. The trader need not try to calculate the standard deviation of volatilities. This is done for the trader by different analytical services. For example, Optima Investment Research generates standard deviation ranges for five currency futures pairs.
This provides a use- ful source for linking volatility and price movement, and also for identifying resistance and support ranges since the market prices sometimes bounce off the one- and two- standard-deviation price levels see Table 2. Seeing this, the trader would look to 1. There are several strategies. A range trading strategy reflecting this chart would suggest a sell of 1.
The sigma charts provide a unique and quick way of targeting option strike prices based on volatility. Spotting a Volatility Cone If a trader spots a volatility cone, then there is an opportunity to detect and conjecture which options are overpriced or undervalued. In the volatility cone chart in Figure 2. Source: Optima Investment Research, www. This allows traders to trade volatility directly. The concepts of historical and implied volatility were reviewed. Important vi- sualizations of volatility are also available to the trader, and software presenting volatility surfaces and smiles become important elements of trading options on the currencies.
To help the trader, many software services are now available that offer sophisticated ana- lytics on volatility. S It is a process resulting from an evaluation of market conditions. The selection process is very much subjective. To be successful, it requires that the trader adopt a preferred direction where he or she has maximum confidence in the result.
Gaining confidence about a direction of a forex option trade involves understanding several di- mensions, explained in detail in Chapter 3. In addition, you will find an introduction to the binary options on the FOMC decisions as well as instruction on using housing sector data for developing forex option direction decisions.
Of all of the factors moving currency prices, this is the most important and will be discussed in greater detail later in this book. The following column appearing in Bloomberg is a typical example of commentary throughout the year regarding interest rates and a currency direction. To make a decision on anticipated direction, the forex trader can use the interest rate expectation calculator found at www. DOWN 0. Technically, we mean the action the FOMC makes on the federal funds rate at its meetings.
These are the interest rates paid on loans made between banks also known as depository institutions. The Federal Reserve therefore uses the policy tool of increasing or decreasing these loan rates to achieve policy goals. A currency will strengthen if the market perceives that there is reason for interest rates to increase. The market forms an expectation about the next central bank deci- sion on interest rates. This expectation then governs the sentiment between central bank meetings.
So the first thing that a trader needs to do is to group the world of currencies into three groups: currencies with interest rates expected to go up, currencies with in- terest rates expected to go down, and currencies with interest rates expected to stay the same. The forex trader must consider these correlations between interest rate ex- pectations and direction in shaping the duration of the trade.
There are now very effective ways of anticipating FOMC decisions that we will demonstrate in the next section. How can the trader answer this question and go beyond just guessing? Answering this question is the focus of a great deal of work throughout the world. For the readers of this book how- ever, there is a very effective way and it is in fact supported by official Federal Reserve Bank analysis. This important tool should be understood by forex traders.
The fed fund futures contract is cash settled to the simple average overnight fed funds rate for the delivery month see Figure 3. The basis for obtaining a strike price by the subtraction of the targeted rate — , allows for the market to bet not only on whether the FOMC will change rates but also on how incremental the change will be.
The options market can be used to estimate the probabilities associated with several possible paths for the target federal funds rate over the next several FOMC meetings. An important study concluded that options on federal funds futures provide a simple but powerful means for extracting market expectations for the possible outcomes of FOMC meetings. In other words, the forex trader who wants to trade the FOMC decision can use the federal funds option information to help identify the probabilities involved in an impending decision.
The trader has to be more quantitative about it. A bet- ter way to express it is that rates can go down or up in increments of 25 basis points www. So our focus here is on presenting the best direct tool for enabling the trader to get an informed opinion about what the FOMC will do and also actually trade the FOMC decision directly!
The forex option trader is very fortunate because the federal funds contract has a revolutionary option on it—binary options traded on the CBOT. A good source for review for those who want to become familiar with binary options on the fed funds is www. Here is how it works. There are only two payout possibilities. The up-to-date settlement values can be found at: www. The target is converted into an option strike price. So a target of 4. In other words, the trade gets strike prices that allow an anticipation of what the FOMC meeting will do.
The binary option is on the underlying federal funds rate directly. This contrasts with options on the average federal fund rate. The contracts also cover the next four meetings, so it provides a longer time frame as well. Also there is no other outcome. The trader either gets or gets 0. In a regular option purchase, the risk is limited to the premium paid, but the gain can vary. Figure 3. We can see that the binary option limits the payout. A major advantage is that the binary option also limits the risk on writing the option.
A trader can in effect play the house and write an option and have no further risk other than owing the difference between what the trader receives premium paid by the buyer and The strike prices are then subject to being bought or sold written. If the trader writes a call at a strike price of The buyer of the 96 strike price is paying a premium and betting that the rates will be — 96, or 4 percent.
The seller believes it will stay above that. The writer of the contract, unlike a plain vanilla option, will have a risk limited only to the difference between and the premium price he received. Here on November 28 was the option price on the December 11 decision. The interpretation of the data below showed that the market is pricing the probability of a cut as 78 percent that the fun rate will be below 4.
For more important information on binary options, refer to the following sources: r John B. Carlson, Ben R. Craig, and William R. If a trader believes that the FOMC will not do anything, he could write a call and write a put. The trader would receive the premium paid him, which is the most he would gain.
The trader would owe the difference between and the premium received if he were wrong. This indicates strong sentiment of a continued decline in interest rates. The power of the binary options is that it allows the trader not only to play a direct decision on the FOMC, but it gives the trader the ability to extract sentiment data and use it in his own trading. This option play allows the trader to trade more than just the next FOMC meeting. He can trade a sequence of events.
What if the trade thinks the FOMC will cut or raise rates one more time and then do nothing? A strategy here would be to buy a put or sell a call if the trader things rates would go up. Or if the trader thinks rates will go down and the FOMC will lower rates, he would buy a call or write a put. For more information on the CBOT binary options on the federal funds rate, take a look at these web sites: r www.
For example, here is the COT report on the British pound that indicates big money is neutral as to direction. Together with the volatility surface favoring puts, a trader inclined to trade puts on the pound has gained more confirming information.
In the COT graph, as shown in Figure 3. One of the most powerful capabilities offered to us by the COT is the ability to see a representation of market sentiment by the largest of players. In Figure 3. This is a representation of market equilibrium, using past experience as our gauge; this is generally indicative of two things: 1.
Stagnation, as the market tries to determine the next new trend. A breakout will be fueled by both sides trying to jump on the next big move. It trades on the Liffe Exchange. For exam- ple, the June contract price was at This translates into — This is an implied percentage and if the market was anticipating the EUR rate coming down, this contract would go up in value.
But the trader can look at option data to derive some further confirmation regarding a consensus on direction. A weak housing market portends a decrease in rates while a strong housing market raises fears of inflation and, therefore, market anticipation of interest rate increases or at least not cutting rates.
The trader needs to keep an eye on key sources of housing data and develop a focus on key indica- tors and data for each currency pair. Luckily, there is a plethora of information available. KB Homes For shaping a directional opinion on the U. Its stock price is a leading indicator of the housing market strengths or weaknesses. We can see in Figure 3. A forex trader who wants to anticipate whether the FOMC will stop lowering rates or will increase rates will be on high alert if the price breaks its downtrend line.
We can see clearly that KB Homes, at the start of , began a downtrend, coinciding with weakness in the overall housing market. A put on the stock would correspond to a bet that U. This shows that the sentiment on the housing market recovery was significantly bearish. The forex trader should watch this ratio periodically to see if it changes. If the ratio swings toward the call side, the trader should carefully consider calls on the U. In , KB Homes had a The forex trader looking for a leading indicator of a housing recovery would want to see the price break the downtrend line.
The option would need to be longer term to give time for the economy to start recovering. It hit a high on December 27 of This data showed that the mood of the market was still very bearish see Figure 3. We can look at one more important piece of information regarding sentiment on this equity. We can compare the premium price of calls and puts.
If the trader were to shape an option trade on the recovery of this stock and its breaking of a downtrend, he might consider an April 19 option and determine whether it is indicating the same bear sentiment. Also, it is beneficial to be looking at the volatility data. The volatility of this option is If it starts declining, it could be a sign of a bottoming out. Leading U. The housing sector is a reliable indicator in almost every country that has a floating currency.
The British Pound This currency movement went to historic highs against the U. The cause was a fall in housing prices after a decade-long boom see Figure 3. We see a sharp skew in the implied volatility of the puts over the calls. Also, when looking at a the premium prices of options pips away from the spot price, we see a skew of the put premiums nearly twice the calls.
Finally, for those who have access to the data, the 25 delta risk reversals show also favoritism for the puts see Figure 3. Australian Dollar and Housing Data Another example of how housing data in- fluenced currency price direction and anticipation of interest rate decisions is that of Australia see Figure 3. Here is what Bloomberg reported on January 8: Jan.
The currency gained from the weakest in two weeks as traders raised the odds the Reserve Bank of Australia will increase its 6. The Australian dollar advanced 0. It earlier touched The currency rose to Investors expect the cen- tral bank will raise its overnight cash-rate target by at least a quarter-percentage point to 7 percent in the next 12 months, according to a Credit Suisse Group in- dex based on trading in interest-rate swaps.
The odds of a quarter-point increase within a year were 92 percent yesterday. Japan Housing Data Traders of the yen will find Japan housing data as an impor- tant factor in expectations regarding the Japanese economy.
Housing start data provides a poten- tial leading indicator of whether the Japanese economy is declining, stalling, or growing. It is estimated that housing decline had at least a 1 percent re- duction in Japanese gross domestic product GDP. But in January , data showed a bottoming out of residential dwelling started see Figure 3.
Reports in March indicated that the decline in housing starts in Japan may have reached a bottom. An increase in housing starts is also correlated with related industries such as building materials. Construction orders also rose see Figure 3. Keeping an eye on Japan housing data makes a lot of sense for formulating longer- term option trades on the yen.
Traders noticing a topping out of housing prices and starts would be justified in selecting a put on the currency pair. Housing statistics data for New Zealand is available from Statistics New Zealand, a government agency. Once again, housing data is a key leading indicator about anticipating a central bank decision. The trader needs to look at Canadian housing starts. Data source: Canada Mortgage and Housing Corporation, www. OTTAWA, January 9, Bloomberg —Housing starts in are estimated at ,, surpassing starts, and reaching their second highest level in nearly two decades.
The data showed a slowdown in the housing starts and the currency pair reacted. Are the patterns in a sideways, uptrend, or downtrend market? As Figure 3. For those traders who want to confirm a bearish strategy on the U. This fund also has options which makes it more capable of generating useful information to the forex option trader. This fund makes money as long as the real estate industry is down.
The results of the spread, seen in Figure 3. First lo- cate the at-the-money ATM strike price or the one nearest to it. The market price on December 28, , is This means that the ATM would be For example, we can choose a strike price of The April call is priced at This indicates that the option sentiment is skewing in favor of a bullish recovery by April since the premiums for the calls are higher than the premiums for the puts.
Option sentiment is not a predictor but simply reflects the consensus of opinion. The forex trader needs to be always ready for surprises in the market and use the ETFs on the key housing sector as a strategic alert providing early and leading indication of changes in this important sector see Figure 3. As long as the bank industry ETF stays within its steep downtrend, there is little support to buy dollars.
A major impact on currency direction is the FOMC decisions on interest rates. The chapter reviewed how option strategies can be shaped around the FOMC deci- sions. Additionally, the chapter focused on how to locate and use housing sector data as a leading indicator for anticipating longer-term currency directions in the currency pairs of the majors.
CHAPTER 4 Tracking Fundamental Directions n this chapter the forex option trader learns to diagnose market conditions in or- I der to develop a currency outlook and directional trading strategy. They provide easy to access information on currencies and key sectors. The role of pur- chasing power parity PPP measurements is reviewed in their ability to help decide an option direction. The trade-weighted index is reviewed as a tool for analysis.
The reader will learn more about the currency—commodity connections and how to use commodity and currency intermarket analysis to shape option strategies. Finally, a currency outlook checklist is provided at the end of the chapter. But ETFs can be used by the forex trader to support a decision on what direction a currency pair should be traded. Many ETFs offer options on the ETFs, and this allows the forex trader to either use the option data for sentiment analysis or even trade the option data.
ETFs on currencies can be grouped as those dealing with the U. The strategy is to identify opportunities to go long the dollar against sev- eral currencies, including the euro, yen, British pound, Canadian dollar, Swedish krona, and Swiss franc. This has not been an easy strategy in recent times. But the point is that this ETF tells a very effective story about the mood of the market.
Its price pattern shows a breakdown in any bullish sentiment. This means they move in opposite directions and are almost always in negative sync! Comparing these two sides of the coin on U. If the forex trader wants insight into whether dollar bearish sentiment is likely to continue or may be nearing a bottom, generating a spread chart would identify if the bulls versus the bears are at their statistical extremes.
If the spread is at the widest point, it is likely to narrow. If the spread is narrowing, then it is likely to widen. This likelihood is statistical in nature and based on standard deviation analysis. So what happens when we spread these two different funds? We get an instant picture of the spread being at its widest point. At the highest the spread was 5. Being at 4.
This would strategically mean that there is a balance between the bulls and bears on the U. PowerShares is a group of ETFs that track sectors relevant to currency analysis and trading. See www. There are many locations to access up to date data on economic growth. Foremost among them is the central banks themselves. Once again, it is a question of timing.
Economies move in cycles and take time to slow down or turn around. This is an area of great ambiguity for the forex trader. The trader has four decision rules: 1. Trade with the current economic cycle. Trade a slowing down of economic growth. Trade a stagnant economy. Trade a growing economy. Central banks do not in- crease rates when growth is slowing down. Also, the trader needs to consider the time frame for the option.
The longer the time frame, the greater the risk of being wrong. But a longer time frame allows time for funda- mentals to work out and express themselves in the price action. The forex option trader chooses a longer time frame to allow for countertrend moves to occur and then resume a fundamental direction.
So, whether a forex option trade should be one week or several months is very much a judgment call. However, there are fundamental criteria for choos- ing a time of duration that should be considered. Depending on the economic conditions, forex option trades can range from very short term to longer term. Basically, a 3-month duration for an option trade will allow a reasonable period of time for fundamental forces to express themselves.
The theory of PPP basically asserts that a good way to detect if a currency is overvalued or undervalued is to compare prices of similar products across countries. A well-known version is the Big Mac index. If one compared a global product such as Coca-Cola, the differences in prices in one country compared to another would demonstrate an imbalance in the currency value. Source: Main Economic Indicators, pp. Here is how the OEC defines PPP: PPPs are the rates of currency conversion that equalize the purchasing power of different currencies by eliminating the differences in price levels between coun- tries.
In their simplest form, PPPs are simply price relatives which show the ratio of the prices in national currencies of the same good or service in different coun- tries. For example, if the price of a hamburger in France is 2. This means that for every dollar spent on hamburger in the United States, 1. The task of the forex trader is to access the PPP information in a timely way and use it to determine a potential direction for the trade.
Since the pro- cess of reverting back to a mean PPP takes time, it is a perfect application of longer-term option trades. The most overvalued currency was the Swiss franc, and the most undervalued was the Chinese yuan. The euro appears overvalued by 23 percent and the British pound by 18 percent.
In contrast, the Mexican peso, The British pound, the yen, and the yuan were undervalued, suggesting purchasing longer-term calls on these cur- rency pairs. Where the strike prices should be can be suggested by the prediction that these currencies will retrace by at least 50 percent of the amount they are calibrated to be overvalued or undervalued.
The duration of the options should be longer term than most, six months to a year! Of course, variations such as put and call spreads can be applied as well as combinations such as shorting the spot underlying and buying protec- tive hedges. The Big Mac Index, July 5, , www. Figure 4. As a result, the forex trader can play a long-term reversion to the PPP equilibrium by buying puts and put spreads on the overvalued pairs and calls and call spreads on the undervalued pairs.
It is worthy to note that the yen and the New Zealand dollar are the closest to their equilibrium point. This suggests trades of a shorter-term nature. Source: www. Tracking Fundamental Directions 87 2. Which are overvalued and undervalued based on the Big Mac theory? A useful exercise would be to compare how predictive these charts Figures 4.
At the end of , the U. The PPP chart in Figure 4. It is based on long-run PPP estimates of the U. A forex trader using this chart could put on a long-term call on the dollar for a potential dollar bounce. These indexes are used by economists and central banks to forecast trend di- rection and currency strength.
They can be easily accessed at www. See Table 4. The main question facing the forex trader that the TWI can answer is: Is the currency getting stronger or weaker? While traders trade one currency against another, the ques- tion of how strong a currency is can be answered in reference to the trade basket of that currency.
The TWI baskets generate an index that provides a useful clue as to whether a currency is globally stronger or weaker from its trading point of view. The TWI chart for shows a breakdown of a strengthening uptrend in the GBP at the end of July , and there- upon a beginning of a downward channel. This suggested fundamental reason to antici- pate a decline of the GBP.
The forex trader using TWI patterns was able to anticipate a change in direction, if not an immediate one. The trader should not be surprised that a particular currency pair is moving opposite to the direction suggested by the TWI patterns. Trade patterns take time to impact currency moves. This, however, is a very good sign. The trader can wait for the market to come to him see Figure 4.
Among the most important commodity—currency connections are the gold, copper, and oil sectors. Scanning these sector commodity price patterns can give the forex trader early identification of impending changes in the currencies that are closely related to them.
Tracking Fundamental Directions 95 The major commodity—currency connections are important because ultimately they provide very effective data for preparing forex spot and option trading. This makes sense because world trade essentially provides the reason for the currency—commodity con- nection. A country produces a product and exports it to another country. The producer needs to get paid for the product.
This means that the buyers of the product have to take their currency and convert it to the currency of the producer of the product. So when China buys Australian copper, there is money flow converting Chinese renminbi to Australian dollars. The top commodity—currency connections involve several commodity sectors. These include oil, gold, copper, and agricultural exports such as sugar. It is a rational deduction that the currencies of the countries that produce these commodities will be affected by events that impact those commodities.
The correlations between price action in these commodities and currency prices are seen in Figure 4. The close correlation between commodities and currencies can be easily seen in Figures 4. We see oil and the Canadian dollar in sync with each other. While oil and gold are the most popular commodities that impact currencies, there are others as well. Tracking Fundamental Directions 97 to copper since Australia is the second-largest producer of copper and its currency is readily tradable.
Tracking commodity markets is becoming easier for the forex trader. The ETFs are valuable resources for tracking these commodity patterns. By monitoring ETF price action and option information when available the forex trader can obtain an edge in developing an accurate diagnosis of conditions in the commodity markets as they relate to forex price action. There is a growing number of ETFs providing tracking of key commodity sectors.
A good idea is to access their web sites for detailed information. There are many dimensions that define the optimal condition for a forex option trade. Certainly, foremost among them is the nature of the price action. But at the start of the process is the overall fundamental environment of the price action. It is essential for the trader to develop a currency outlook for all of the currency pairs. In order to do this, the trader can use the following currency outlook checklist to establish a framework for deciding on the direction of a currency pair.
The currency outlook checklist serves to keep the forex trader accountable to assessing fundamental issues. These are too often overlooked. The forex trader will greatly benefit by being able to complete this checklist. Some traders will look to be very detailed, while others will be more cursory in their decision process. Ultimately, anticipating a direction is the key first step in developing a forex option strategy.
An Excel spreadsheet input form of the currency outlook checklist is available at www. Currency Outlook Checklist 1. Inflation Latest Central bank target Actual target 3. Possible Recession Housing starts Home price Yield curve inversion 5. Dollar Sentiment Central bank currency reserves of dollars U.
Commodity Markets Gold Commodity index Oil 8. Treasuries—declining SUMMARY This chapter provided a review of how a forex option trader can build a fundamental knowledge base to help shape a decision on what direction to select for his next option trade. Important also is analysis of commodity markets. A currency outlook checklist is presented as an aid to analysis. Chapter 5 reviews important chart patterns that identify condi- tions for entering a trade and display market sentiment.
These patterns include parabolic paths, volatility envelopes, and channel patterns. Trend reversal patterns can be identified using three-line break charts. There are also potential useful applications of Elliott wave theory. Chapter 5 also reviews the role of currency pair correlations in identifying forex option trading opportunities. The most important are B parabolic paths, Bollinger bands, channel patterns, and three-line break charts.
All provide useful tools in confirming the direction of an option trade and shaping strategies for selecting strike prices and direction. While the direction of the option trade can occur based on fundamental analysis, the trader has to compare the conclusion to buy or sell with the reality of the price action. The best way to begin is to detect the presence of patterns in the currency pairs. Because patterns in forex are not random Brownian motion, they reflect human de- cisions and crowd behavior and they therefore provide the best clues for diagnosing mar- ket sentiment.
Is the pair in a strong, weak, or stable trend? Is its price action gaining or losing momentum? Is it exhausting? Is it probing trend lines? Is it confirming reversals? Is there a frequency to the pattern that is repeating an earlier pattern? The answers to the questions provide a virtual map of the price action. The parabolic price reaches an apex of nearly 90 degrees and cannot sustain itself.
It becomes a prelude to exhaustion and possible reversal see Figure 5. Extreme Bollinger Bands A good way to identify exhaustion patterns and the location for whether a strike price is in an area likely to be reached is to use the weekly charts and use extreme Bollinger bands EBBs. This is a setting of 13 periods and 2. The trader looks for a currency pair to be probing an EBB, and that price area can be used as a strike price that is selected.
A forex option trader, seeing that the price is hugging the standard band and refusing to bounce off it, would also note that the extreme band has not been touched. This would be a bullish conclusion. The price has room to keep going up. But when the weekly candles started touching the extreme outer Bollinger bands, the trader can start thinking about a retracement possibility or at least the price getting tired. They can use the location of the EBBs as potential areas for selecting an option target.
Trades, particularly option strategies anticipating range behavior, can benefit from using the EBBs. Channel Patterns Channel patterns can be sideways, uptrending, and downtrending channels see Figure 5. They indicate stability and a persistence of sentiment. The trader can use channel patterns to shape target strike prices for entry and exit. Read More Detail Click Here. How to succeed in binary options trading. Search this site. About Binary Option Trading.
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