Selling the strangle in forex options

Selling the strangle in forex options

Cordier, James

Currencies generally are good trending markets, but when the trends dry up, many currency traders give back profits. But if you understand option strangles, you can position yourself well for any forex market environment.

The rising popularity of forex trading is drawing novice and experienced investors alike to both the electronically traded Chicago Mercantile Exchange fotex futures and off-exchange forex dealers to try their hand at outguessing the pros at international monetary policy. These are indeed exciting markets, and many believe they also tend to move in trends and trend longer than some other markets, making them more appealing to trend traders.

However, trying to time daily or even weekly price moves can be tough in any market, let alone currencies, which have so many daily factors affecting price that you could not possibly hope to follow half of these variables with any consistency. Yet, longer term, big picture trading in currencies may seem more clear-cut to many traders who follow the worldwide economy.

Luckily, there is a way to trade the higger, overall picture in the currency markets without subjecting your trades to the daily whims of the market.

Enter option selling. Selling out-ofthe-money puts or calls far below or far above a current market price allows the trader plenty of room to be wrong in the short term. In most cases, these strategies enable a trader to withstand temporary adverse moves and remain in a position long enough for longer-term projections to prove correct. In addition by selling an option, a trader does not necessarily have to decide where the market is going, only where it is not going.

OBVIOUS OPPORTUNITIES

For instance, in late October, a trader bearish the Japanese yen could sell December call options on yen futures with a 98 strike for close to $400 each. If the December yen is anywhere below 98 at option expiration on Dec. 3, the option expires worthless and the seller keeps all premium collected as profit (see “Calling for profits,” above, right).

Likewise, a trader bullish a particular currency could sell puts far beneath the market. Thus, the trader puts himself in a position to profit even if the market experiences corrections before ultimately moving higher.

Such an example would be in the British pound back in September. A trader looking for the pound to gain on the dollar could have sold November 76 British pound puts in mid to late September. Even if the trader sold the puts on the rally in late September, his options would still have been out of the money at the bottom of the correction in early October. How many futures traders would still be in such a trade? The market ultimately resumed the rally and the puts eventually expired worthless (see “Puts on parade,” below).

Selling straight puts or calls works best in trending markets or markets where the trend is reversing.

DISSECTING THE APPROACH

Selling options not only allows traders to focus on the bigger picture in the forex markets, it also can be a flexible and forgiving strategy. However, there are some caveats to selling currency options.

Although trading CME options lets an investor trade on a regulated exchange, currency options can have thin open interest in some strike prices. There are futures contracts for March, June, September and December in most currency contracts, but there are options available for nearly every month. The interim months offer options based on the next available futures month. For instance, November euro options would have the December euro futures as the underlying contract.

Open interest and volume tend to be higher in futures contract months and not quite as high in the interim months. While small speculators shouldn’t have much problem trading either of these, larger traders should seek out the more liquid contracts.

Also, selling options can potentially entail the same risk as a futures contract – theoretically unlimited. Sellers of options should plan to exit their positions (buy the option back to close) before an option goes in the money. An in-the-money option can gain value quickly. This clearly is the opposite of what an option seller wants to happen.

Yet, options can gain value even if they are not in-the-money. While time value ultimately will erode the value of the option (especially in the last 30-60 days prior to expiration), prices moving rapidly toward a strike price can cause the option to increase in value. For this reason, you may want to consider a slightly more advanced strategy that can protect the downside.

CURRENCY STRANGLER

Because options can increase in value without actually going in the money is why strangles become such an attractive strategy. A strangle is an option strategy where the trader sells a put and a call on the same market. This also is known as “bracketing.”

The strangle can be a profitable approach as long as the futures price is anywhere between the two strike prices at option expiration. The added benefit of a strangle is this: If the markct is heading toward one strike or the other, the increasing value of the nearer strike price is offset, at least partially, by the decreasing value of the option on the other side of the market. This offsetting effect allows the market even greater flexibility to fluctuate, as long as neither strike price is exceeded.

For instance, many traders over the summer found difficulty in trying to trade the non-trending forex markets such as the euro. The market’s backand’forth range trading during this period frustrated trend traders.

Yet, traders selling 119 puts and 126 calls on the September euro contract could have collected excellent premiums, experienced little drawdown, and made exceptional profits in June, July or August (see “Euro of opportunity,” left). When the market rallied, the 126 calls gained value but the 119 puts lost value, offsetting the loss. The same was true when the market fell back, as the calls offset the increased premium in the puts. This balancing act continued while time value gradually eroded both options until they expired worthless in September.

Strangling works best in non-trending markets where lots of back and fill action is the norm. This is why option strangles may be the optimum strategy for currency traders in the current state of the market. While the dollar recently broke through to new lows and other currencies such as the euro and pound recently broke out to new highs, the chances for currencies settling back into new trading ranges is very good.

High oil prices have helped drive the dollar to new eight year lows in 2004. But higher output should allow stockpiles to begin to build in the first quarter, which should help the dollar recover. At the same time, talk of the U.S. government intervening to prop up the dollar would no doubt be supportive as well. But don’t expect it to happen overnight. Slowdowns and lost revenues from high oil prices will be felt for months to come, more so in the United States and Japan than in Europe.

Therefore, while chart breakouts will almost certainly occur in the coming months, markets such as the euro, yen and pound could spend a good part of 2005 trading in somewhat defined ranges. Identifying these ranges is the key to profits in strangling the market.

A trader willing to forego the day-to-day action of forex futures trading and simply sell far out-of-the-money puts and calls outside of these price ranges may be in a position to reap the greater rewards over the long haul.

James Cordier is the president and Michael Gross is the director of research at Liberty Trading Group, a futures brokerage and CTA specializing in option selling. They can be contacted through their Web site at www.libertytradinggroup.com.

Copyright Futures Magazine Group Dec 2004

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