Listed or regularly traded options for stocks and commodity futures have been available totraders since the 1970s. However, options are new to FOREX and are definitely worth exploring.I recommend options as a money management technique and not as aprimary trading vehicle. Option theory can be enormously complex mathematically, but if you stay with the basic ideas you might find them a worthy addition to your codex. If you Google “option trading,” you will find many primersand in-depth resource guides on the Internet.
What Is an Option?An option is the right to buy or sell something at a specific price for a specificperiod of time. Buying an option is essentially buying time.One advantage of buying an option is that your loss is limited by theprice you paid for the option; you can never lose more than that amount.
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Option TermsAt-the-money.An option is at-the-money if the strike price of the option is equal tothe market price of the underlying security.Call. An option contract that gives the holder the right to buy theunderlying security at a speciﬁed price for a certain ﬁxed period oftime.Put. An option contract that gives the holder the right to sell theunderlying security at a speciﬁed price for a certain ﬁxed period oftime.Strike Price. The stated price per share for which the underlyingsecurity may be purchased (in the case of a call) or sold (in the caseof a put) by the option holder upon exercise of the option contract.Time Decay. A term used to describe how the theoretical value of anoption “erodes” or reduces with the passage of time.Both www.cboe.com and www.phlx.com have complete glossariesof options terms.Courtesy www.CBOE.com.
Types of OptionsPrincipally, there are two types of options. The right to buy is a call. The rightto sell is a put. You are said to have the right to “call” the stock, commodity future, or currency if you purchase a call. You are said to have the right to “put”the stock, commodity future, or currency if you buy a put.Puts and CallsA call is the right to purchase the underlying long currency. A put isthe right to sell the underlying long currency. In FOREX, thisessentially means being long the other currency in the pair or cross.
Of course, someone must give you that right to call or put. That person isthe other side of your options contract and is termed the writer. As a FOREXtrader, you may consider being either a buyer of put and call options or awriter. Buying is simpler and more common. Writing and its various permutations can become complicated and should be considered only by the traderwith substantial market experience.
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FIGURE 15.1 Complex Option Strategies.You may either buy (purchase) calls or puts or you may write calls or puts.Writing options is beyond the scope of this book but involves manycomplex strategies that appeal to advanced traders. Exotic strategies involvecombinations of puts and calls as well as both buying and writing. Theyoften have names based on the visual outline of the strategy. Writing mayalso be used as a money management tool.
Complex strategies with esoteric names such as butterfly and condor refer tosimultaneous buying and writing of calls and puts for different strikes and exercise prices. These are definitely best left to the options specialist! See Figure 15.1.Options for Money ManagementAs a money management technique, buying calls and puts may serve as an insurance policy on your trade. Typically, they work best if you plan to hold atrade for some period of time, which is not a common prospect for the currency trader.An insurance policy protects you against the opposite outcome from whatyou expect or desire. If you buy life insurance, it protects your heirs if you die.If you are long a currency against another currency—for example, EUR/USD, where you are long the dollar—you may purchase a USD put against theEUR as protection. If your stop is hit or the market goes against you, yourlosses are mitigated by the profit in your put.
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If you are short a currency against another currency—for example, theEUR/USD, where you are short the dollar—you may purchase a USD callagainst the EUR as protection. If your stop is hit or the market goes againstyou, your losses are mitigated by the profit in your call.It sounds wonderful, doesn’t it? Unfortunately, calls and puts cost money;the cost of an option goes to the writer for giving you the calling or puttingrights. You must calculate the cost of your option against the value of the insurance protection. Sometimes it works out to your advantage, but often it doesnot—primarily because of the cost.When buying an option, you are paying for the time. The more time youpurchase, the higher the cost. As the market moves, that time gets shorter andshorter. The time value of an option is said to decay. My experience is that thisdecay is very difficult to calculate in advance. See Figure 15.2.The closer your option is to the strike price, the more expensive it will be,as well.The twin factors of decaying time and fluctuating prices of the underlying instrument make options pricing very difficult. You can win but still lose.Win and Lose
Value
It is not uncommon for the options trader to apparently win and yetlose. The price of a currency may go in the direction, generating anunderlying price proﬁt. But the time value may erode at a fasterrate, causing the value of the option to fall, not rise.To win, the price proﬁt in an option must increase at a greaterrate than the rate at which the time value decays.
Expiration
Time
FIGURE 15.2
Options Decay.
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I do not recommend trading options as a substitute for cash or spotFOREX. Other than the slight carrying charges for spot currencies, very littlecost is involved beyond the bid-ask spread. I’ve also found that options tend tomake a trader lazy and lax. Because your loss in buying a put or call is limitedto the price you paid, its value can only go to zero. Inexperienced traders tendto put off decisions from one day to the next, only to see the option expire,worthless, and their money lost.Caution: If you trade or use options, trade only with a reliable broker/dealer or options exchange. The Commodity Futures Trading Commission(CFTC) and the National Futures Association (NFA) have logged hundreds ofcomplaints from people who have been swindled by options from disreputabledealers or “boiler shops.”The Philadelphia Options ExchangeThe Philadelphia Options Exchange (PHLX) has recently introduced optionson FOREX. The number of options is quite limited at this time (see Table15.1). Listed stock options trading began in the 1970s with very few options,and now thousands are offered. I expect a similar course in listed FOREXoptions as professional traders and hedge funds accept them as a legitimatetrading tool. The PHLX (Philadelphia Options Exchange) has been in businessfor many years and has an excellent reputation. Go to www.phlx.com for moreinformation, including excellent educational resources.TABLE 15.1 PHLX OptionsAUD
GBP
CAD
EUR
JPY
CHF
USD
AUD
1
0.4103
0.9319
0.6048
95.2300
0.9823
0.8086
GBP
2.4338
1
2.2708
1.4731
231.8200
2.3916
1.9673
CAD
1.0731
0.4404
1
0.6491
102.0700
1.0530
0.8661
EUR
1.6510
0.6786
1.5407
1
157.3400
1.6229
1.3350
JPY
0.0105
0.0043
0.0098
0.0063
1
0.0103
0.0084
CHF
1.0177
0.4182
0.9492
0.6163
96.9100
1
0.8221
USD
1.2367
0.5083
1.1528
0.7491
117.8200
1.2152
1
Source: www.PHLX.com.
Box OptionsFOREX brokers and dealers are also beginning to offer options. The optimumstrategy is, of course, to trade both spot currencies and FOREX under the sameroof. The logistics of doing otherwise may be very difficult, if not impossible insome cases.
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FIGURE 15.3
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Box Options.
A FOREX broker-dealer, OANDA Corporation (www.oanda.com), nowoffers box options. These are preset options packages. They are called box options because you are trading in a box defined by time and price variables.OANDA’s parameters for their box options are not in the public domain,so to some extent you are trading blind. Nonetheless, they are quite interestingand open up any number of opportunities for the FOREX trader. See Figure15.3. (It is probably possible to reverse-engineer the OANDA box option parameters, given enough sample trades. This may or may not be valuable information insofar as the broker/dealer might simply reset the parameters at any time.)
SummaryI recommend options as a money management tool only to intermediate tradersand up. Be comfortable with your trading method before considering options.The same can be said for adding any new trading tools to your codex. If you are aposition trader, options most definitely bear consideration. Options writing andcomplex strategies should be left to the advanced trader and professionals. I do notrecommend trading options as your primary vehicle, in place of spot FOREX.It’s fun and exciting to explore the world of technical analysis. But it canbecome an addiction and a detriment to your trading. Don’t add a technique toyour codex unless you are very comfortable with using it and you understandclearly what it does and what it actually measures.Many are the traders who have lost the forest for the trees in the pursuitof technical analysis.
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16Chapter
The Dreams of Reason—To Be or Not to Be aFOREX TraderWalking away is better than being carried out.—Charles B. Goodman
ill you wave a currency trader’s checkered flag or a white towel?FOREX trading is great fun. It can also be very profitable. But thereality is, it is not for everyone. There may be many reasons tradersfail at FOREX. Some are common and correctible. It is worth reviewing thecharacteristics of a successful trader from Getting Started in Currency Trading.
W
Nine Characteristics of Successful Traders1. Successful traders tend to have absolute control over their emotions—they never get too elated over a win or too depressed over aloss.2. Successful traders seldom think of prices as “too high” or “too low.”3. Successful traders do not panic. They make evolutionary adjustmentsrather than revolutionary changes to their trading style.4. Successful traders do not flinch at making the decision to take aloss, never let losses ride, and never add to losing trades. One oldtrader told me he thought of his positions as stock in a retail store. If
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something sells and is making you money, you add to that line. Ifsomething is not selling and it’s costing you money, you discount itand unload it as quickly as possible.5. Successful traders treat trading as business and not a hobby.6. Successful traders stay physically fit.7. Successful traders are prepared for all eventualities on any given trading day. They come to work with a plan that includes many contingencies and not just what they hope will happen. In your own tradingprogram you should have predetermined answers to “What happens if. . .” prices open sharply higher or lower, the market is very quiet, themarket is very volatile, the market makes new highs, the market makesnew lows, the market goes up early and reverses later, the market goesdown early and reverses later.8. Successful traders trade only with money they can afford to lose. Trading FOREX is speculative and can result in substantial loss. It is alsoexciting, exhilarating, and can be addictive. The more you are emotionally involved with your money, the harder it is to make objective,clearheaded decisions about market entry and exit.9. Successful traders adapt to change but never panic.Sadly, we cannot all be winners. There are no specific statistics onFOREX trading, mostly because there is no centralized clearing or recordingmechanism. But I think it is safe to assume that the statistics in FOREX arenot different from those in commodity futures where leverage is also thename of the game. In futures, it is estimated that 90 percent lose and 10 percent win. Not very democratic, but certainly a boon for the 10 percentwinners.If you consistently lose money at FOREX, even after diligently doingeverything possible to win, what’s wrong? No simple answer exists, obviously,or we would all be winners, and the markets would cease to exist. But the issuemay be divided into two categories: emotions and abilities.
EmotionsYou may not be emotionally cut out to be a trader. Because of the leverage inFOREX, mistakes are enormously magnified and quickly make themselves felt.Emotional weakness is harshly penalized. Greed and fear, fear and greed—someof us are better able to control them than others.The best advice I can offer is to start trading very small amounts ofmoney and very small trade lot sizes. Begin trading a demo account, then move
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on to a mini or micro account. Trade progressively as you demonstrate successin lot sizes of $100, $500, $1,000, $10,000, $25,000, and so forth, up to thelimits of your money management parameters.At some point you will notice either a demonstrable fall in your winningpercentages and/or emotional confusion or angst. Drop down one level andstay there for a few months. Then try progressing again. The markets will notgo away; time is on your side.
AbilitiesIt is a mystery why some people excel at some tasks and others, with equal orsuperior intelligence, fail. Consider the game of chess. I’ve played chess for almost 40 years, and although I have attained a lower degree of competence—an“Expert” rating—it is abundantly clear, despite hundreds of hours of study, Iwill never succeed at the game in any big way.In chess, the theory is that your brain is either wired for the tasks it demands, primarily visualization skills, or it is not. If you are wired correctly, youplay good chess, study or no study. This explains the existence of child prodigies such as Capablanca and Reshevsky. World champion Garry Kasparov refersto it as the “chess geometry” ability.Trading may have a similar paradigm. There is probably a neural wiring,or at least a set of least innate traits or propensities, determining success or failure in the markets.I’ve certainly seen some very smart people try very hard, work extremelydiligently, and still go bust in short order. I’ve also seen, less frequently, peopletake to trading as if it were as natural as talking. What those traits or propensities might be, I do not know. But without them, long-term success may be difficult to achieve.Some of the best traders seem to have few skills outside the trading arena;trading is truly their life. Bill Gates is the world’s richest man, but no one whohas heard him speak without notes would accuse him of being the sharpestknife in the drawer!It’s possible you can develop those traits to some degree; I have tried to assist you in that with this book. But without the wiring, only so much may bepossible. An acorn becomes an oak tree, not a blueberry bush.Develop a simple codex. Emphasize money management and style overtrading tools. Remember what Charlie said: “The markets can only go up ordown.” Don’t make it complicated simply because it is possible to have a battery of 37 different technical indicators. With a simple trading plan, errors aremore easily seen and analyzed, and adjustments can be made to a simple planmuch more easily than to a complex one.
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If you’ve failed only marginally at FOREX and have the determinationand money, keep trying. But if you go down in flames in one tradingcampaign after the other, it may be time to wave the white towel and moveon to another area more fitting to your emotional makeup, your specifictraits, or your wiring.One More TimeIf your FOREX venture has failed, but you are willing to try one moretime, take the following steps:1. Take a month off and don’t look at or think about the FOREXmarkets.2. Take the next week to make a list of what you think went wrong.Make corrections and aim to greatly simplify your trade plan.3. Adjust your trade plan accordingly.4. Allocate your capital using the campaign method in Part One.5. Trade your most successful currency pair and no others for30 days.
I wish you success in FOREX trading and in all life’s endeavors.
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AAppendix
Visual Basic Source Code
ver the years, I have written numerous trading programs and backtesting utilities for commodity futures and currencies. The following Microsoft Visual Basic 6.0 source code outlines a program I designed tocalculate moving directional movement and volatility indexes for market environments; the code was written by my colleague James Bickford as part of alarger programming task.
O
Public Type QUOTE_TYPEDate As DateTime As StringO As DoubleH As DoubleL As DoubleC As DoubleEnd TypePublic Q(MAXQUOTES) As QUOTE_TYPEPublic Sub CalculateDM(DMIdx%)Dim i%For i = DMIdx + 1 To NumQuotesDM(i) = Q(i).C - Q(i - DMIDX).CNext iEnd Sub
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Public Sub CalculateVolatility(VolIdx%)Dim i%, j%Dim sum#, mean#sum = 0For i = VolIdx To NumQuotessum = 0For j = i - VolIdx + 1 To isum = sum + Q(j).CNext jmean = sum / VolIdxsum = 0For j = i - VolIdx + 1 To isum = sum + Abs(Q(i).C - mean)Next jVol(i) = sum / VolIdxNext iEnd Sub
The block of code to calculate the impact ratio follows:Public Sub CalculateImpact(ImpactIdx%)Dim i%For i = 1 To NumQuotesImpact(i) = 100 * Abs((Q(i).C - Q(i).O)) /(Q(i).H - Q(i).L)Next i
End Sub
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BAppendix
How the FOREX GameIs Played
here are two types of retail FOREX brokers: market makers and electronic communications networks (ECNs).An ECN works similarly to how the interbank foreign exchange marketworks. Orders are matched on a client-to-client basis. A large network ofbanks, institutions, and traders connect to the network and orders arematched; there is no central clearinghouse for orders. If you wish to sell 50million U.S. dollars (USD) dollars against the euro (EUR), you place yourorder and wait for someone who wants to buy. Typically, because of the hugevolume of foreign exchange business, transactions are instantaneous. Themarket is said to be liquid. Nevertheless, your order technically requires acounterparty to be executed.ECN retail FOREX brokers build their own network and often tap intothe interbank ECN.
T
Market Maker or ECN?Most retail brokers, especially the smaller ones accepting so-called mini accounts,are market makers. Market makers act as a de facto central clearinghouse for theirclients. If you look closely at market maker web sites and their account documentation, you will see a statement such as, “XYZ-FOREX is the counterparty to alltrades.”
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Market makers typically guarantee execution at the price you want,assuming their data stream touches that price. There are exceptions, however,as I discuss here.Market makers sometimes trade against their own clients. There is inherently nothing wrong with this; that is how they play the game. Trading againsttheir clients performs three useful functions: (1) It provides liquidity, (2) ithelps maintain an orderly market, and (3) it keeps their book from becomingtoo unbalanced. Because they are the counterparty to all trades, if they have500 million USD on the buy side and only 50 million USD on the sell side(this is an exaggeration to make the point—balance is rarely off more than5 percent), market makers are at risk if the USD should fall sharply. Marketmakers often hand off large orders to an ECN or the interbank market tomaintain balance.Market makers are effectively bookmakers. In choosing a market makerbroker, it is good to know how much net worth or liquidity they have in casethey do suffer from an order imbalance. The Commodity Futures TradingCommission (CFTC) is working to set minimum net worth/liquidity requirements for market makers. But this is a work in progress, and FOREX todayremains very much a caveat emptor enterprise.Market makers have been known to “requote” prices—executing an orderthat does not show on their price feed. This is also known as “dealer intervention” and is the number-one complaint traders have with market makers inFOREX.Market makers are often accused of running or harvesting stop-loss orders.To a limited extent this is in pursuit of the three legitimate functions listed earlier. However, if a broker/dealer harvests stops primarily as a profit center,traders are not happy. It is very difficult, if not impossible, to tell if a marketmaker is running stops at all and, if they are, the motive. Such is the capitalistexperience. Because of the lax regulatory environment the inner workings ofretail brokers are more opaque than they are transparent.(If you have access to multiple data streams you can watch for stop harvesting. If one of the streams shows a sharp price spike, resulting in a price severalpips from the maximum or minimum of all the other streams, it is possibly a caseof stop harvesting, especially if it is in an active market with good liquidity.)FOREX markets are said to be “fast” especially after the release of a majornews announcement. This means there is a dramatic increase in price movementand/or volatility. Market makers often dramatically increase their pip spreads(ballooning) for a short period of time under these conditions to maintain orderbalance. Pip spreads have been know to balloon from 2 pips to as much as 30pips for one or two minutes after a Federal Reserve announcement. There arehorror stories of ballooning 100 to 200 pips. Spreads also balloon during inactive market periods when liquidity is low. Traders should either avoid trading
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during these times or at least be aware of this phenomenon. Ballooning spreadsshould be a legitimate market maker function, but many traders believe somemarket makers use it as a profit center technique. Again, caveat emptor.If you trade the News—and I recommend against it for the beginningtrader—use an execution tool such as www.secretnewsweapon.com.Even on an ECN platform, executions in fast markets may be off yourprice by many pips. A 5-pip slippage might not dramatically affect a day traderor a position trader, but it is a very significant cost to the guerilla trader or thescalper.At the highest level of foreign exchange trading there are two games beingplayed simultaneously. The first is simply attempting to determine what pricesare going to do. There is a second, tactical level, less visible but very real.The tactical level demands that the trader (1) know what the other players are doing or planning to do; (2) keep the other players from knowing whatyou are going to do; and, perhaps most interesting, (3) feed the other playersfalse information so their conclusions about what you are going to do or planning to do are incorrect. The typical retail FOREX trader need not concernhimself with this tactical level but should be aware of its existence.Most of the order execution issues of interest to the retail FOREX traderstem from the fact there is no central clearinghouse for currency trading.Many web sites offer broker/dealer reviews. When reading these reviewskeep four points in mind: (1) Satisfied traders generally post less than unsatisfied traders; (2) the larger the broker/dealer, the larger its volume of complaints; (3) a small sample of reviews may not be meaningful; and (4) seeingsimilar complaints on multiple web sites increase the chances of the complaintsbeing legitimate.For reviews check out www.forexbastards.com, www.moneytec.com,www.goforex.com, www.forex-ratings.com, and www.forexreview.org. For others,Google “FOREX broker reviews,” “currency dealer reviews,” “FOREX brokercomplaints,” and permutations thereof.
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Glossary
algorithmic trading Trading by means of an automated computer program; sometimes called program trading.application program interface (API) Computer code or routines for integrating trading programs to a broker/dealer’s trading platform. Most commonly used to allow aproprietary trading program to read and process a broker/dealer’s data feed.appreciation A currency is said to appreciate when it strengthens in price in responseto market demand.arbitrage The purchase or sale of an instrument and simultaneous taking of an equaland opposite position in a related market, in order to take advantage of small price differentials between markets.ask price The price at which the market is prepared to sell a specific currency in a foreign exchange contract or cross currency contract. At this price, the trader can buy thebase currency. The ask price is shown on the right side of the quotation. For example,in the quote “USD/CHF 1.4527/32,” the ask price is 1.4532, meaning you can buyone U.S. dollar for 1.4532 Swiss francs.at best An instruction given to a dealer to buy or sell at the best rate that can beobtained.at or better An order to deal at a specific rate or better.balance of trade The value of a country’s exports minus its imports.ballooning The practice by market makers of increasing pip spreads during fast orilliquid markets.bar chart A type of chart that consists of four significant points: the high and the lowprices, which form the vertical bar; the opening price, which is marked with a littlehorizontal line to the left of the bar; and the closing price, which is marked with a littlehorizontal line to the right of the bar.base currency The first currency in a currency pair. It shows how much the base currency is worth as measured against the second currency. For example, if the USD/CHFrate equals 1.6215 then one USD is worth CHF 1.6215. In the foreign exchange markets, the U.S. dollar is normally considered the base currency for quotes, meaning thatquotes are expressed as a unit of $1 (USD) per the other currency quoted in the pair.The primary exceptions to this rule are the British pound (GBP), the euro (EUR), andthe Australian dollar (AUD).bear market A market distinguished by declining prices.
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GLOSSARY
bid price The price at which the market is prepared to buy a specific currency in aforeign exchange contract or cross currency contract. At this price, the trader can sellthe base currency. It is shown on the left side of the quotation. For example, in thequote “USD/CHF 1.4527/32,” the bid price is 1.4527, meaning you can sell one U.S.dollar for 1.4527 Swiss francs.bid/ask spread
The difference between the bid and offer price.
big figure quote Dealer expression referring to the first few digits of an exchange rate.These digits are often omitted in dealer quotes. For example, a USD/JPY rate might be117.30/117.35, but would be quoted verbally without the first three digits, that is,“30/35.”BLS
Bureau of Labor Statistics.
book In a professional trading environment, a book is the summary of a trader’s ordesk’s total positions.broker An individual or firm that acts as an intermediary, putting together buyersand sellers for a fee or commission. In contrast, a dealer commits capital and takes oneside of a position, hoping to earn a spread (profit) by closing out the position in a subsequent trade with another party.Bretton Woods Agreement of 1944 An agreement that established fixed foreign exchange rates for major currencies, provided for central bank intervention in the currency markets, and pegged the price of gold at US $35 per ounce. The agreement lasteduntil 1971, when President Nixon overturned the Bretton Woods Agreement and established a floating exchange rate for the major currencies.bull market
A market distinguished by rising prices.
Bundesbank Germany’s central bank.cable Trader jargon referring to the sterling/U.S. dollar exchange rate. So called becausethe rate was originally transmitted via a transatlantic cable beginning in the mid-1