where you sold it, so 103 is your breakeven point.As Figure 9.7 illustrates, the short call is a bearish position but with several bigdifferences from the long put:• Your profit is limited to the premium received. Even if the market drops to 90or below, the option expires worthless and you get to keep the $30 you collected from the buyer.• Your risk is unlimited. It’s just like being short the underlying instrument ifprices should rally above the breakeven point.• However, the strategy has a higher breakeven (100 + 3 = 103 breakeven) andtherefore a greater chance of being profitable.• Also, time decay works in your favor by eroding the value of the option eachweek.Buy a Put, Sell a Put Also called a bear put spread or, more generically, avertical spread, this is the counterpart of the bull call spread. In this bearish
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FIGURE 9.7 Sell a call. The call seller has unlimited loss potential in the event of amarket rally and a ﬁxed maximum proﬁt, in this case the $30 received for selling the call.However, the strategy has a higher breakeven (100 + 3 = 103 breakeven) and therefore, abetter chance of being proﬁtable.
strategy you buy a put and help offset the cost of it by selling a cheaper out-ofthe-money put.For example, with the underlying futures at 100 let’s say you buy the 100 putfor 9 ($90 in our example) and at the same time you sell the 90 put for 4 ($40). Youpay out 9 and take in 4 so the net outlay for you is $50 ($90 – $40). Figure 9.8 diagrams the results.Let’s plug in and solve for values in this bear put strategy. On expirationday, if the underlying futures close at 90, the 100 puts you own are worth 10(100 – 90) and the 90 puts you sold are worth zero (90 – 90), which meansyour total spread is worth $100 ([10 – 0] × $10/point). Since you paid $50 forthe spread, your profit is $50. For any levels below 90, the most this spread willever be worth is $100. If the underlying futures settle on expiration day at 100or higher, both options are worthless and you have lost the total amount youspent on the spread, in this case $50. The breakeven point for this trade is95 (100 – 5).The benefits of a bear put spread are similar to those of the bull call spread. Inexchange for limiting your profit (in this case during a sell-off) you lower your total investment in the trade, improve your breakeven point, and gain some protection against time decay.
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FIGURE 9.8 Bear put spread. Hedging a put by selling a less expensive put against itlimits the maximum proﬁt of the trade. The beneﬁt is that you lower your total investmentin the trade, improve the breakeven point, and gain some protection against time decay.
Sell a Futures Contract, Sell a Put Also called a covered put or syntheticshort call, this is the bearish counterpart of the covered call strategy. With thisstrategy you would sell short the underlying futures and hedge the position by selling a put.With this strategy you are bearish the underlying futures but are agreeing inadvance to buy the position back at the strike price in the event of a sell-off. In exchange for limiting the potential profit of the trade, you gain a more favorablebreakeven point and enjoy favorable time decay erosion. In a profit/loss diagram,this strategy looks identical to the short call strategy (see Figure 9.7)—limitedmaximum profit, unlimited risk of loss, but a more favorable breakeven.Options strategies discussed so far are for investing with a bias to either theupside or the downside. But what about investing for a sideways market?
Trading a Sideways MarketMarkets can trend up or down, but they can also trend sideways. Some options positions are designed for just this type of market condition.Sell a Call, Sell a Put Commonly called a short straddle (when using thesame strikes) or a short strangle (when using different strikes), these strategies
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seek to profit during a sideways-trending market by collecting the time decay onboth sides of the market.For example, with the underlying futures at 100 let’s say you sell the 100 callfor 6 ($60 in our example) and at the same time you also sell the 100 put, also for 6($60), for a total of $120. Notice that exactly at-the-money puts and calls will havethe same value. If your forecast of a trendless market is correct, time decay willwork in your favor by eroding the value of the options on both sides of the market.Figure 9.9 diagrams the results of this short straddle.Let’s now plug in and solve for values in the short straddle. If the marketprice settles exactly at 100 on expiration day, both options expire worthless andyou keep the entire premium. Chances are small that a market will settle exactlyon a strike price, but the closer the price is to 100 at expiration, the more moneyyou retain.For a settlement price of 88, the 100 strike put is worth 12 (100 – 88 = 12) andthe 100 strike call is worth zero, for a total spread value of 12 (12 + 0), which is exactly what was received for the straddle. So 88 is the lower breakeven point; forany closes on expiration day below 88 the short straddle will have lost money. Theupper breakeven is calculated similarly and works out to be 12 points above thestrike price, or 112.
FIGURE 9.9 Sell a straddle. Simultaneously selling both a call and a put is a way tocollect time decay on both sides of the market. By selling options at the same strike price(a straddle) the proﬁt zone is narrowed, but the maximum potential proﬁt is raised.
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A variation similar to the short straddle is the short strangle. The only difference with this strategy is that the two options sold have different strikes—ahigher-strike call and a lower-strike put. Accordingly, the short strangle hasa wider and flatter profit zone, which increases the chance that the trade willbe profitable on expiration day. Of course, the trade-off for getting this widerrange of profitability is that the maximum potential profit is less than with theshort straddle.For instance, with the underlying futures at 100 let’s say you sell the 105 callfor 4.5 ($45 in our example) and at the same time you also sell the 95 put, alsofor 4.5 ($45), for a total of $90. Just as with the short straddle, in a trendless market, time decay will work in your favor by eroding the value of the options onboth sides of the market. Figure 9.10 shows the profit/loss profile of the shortstrangle strategy.Let’s plug in and solve for values in the short strangle in Figure 9.10. If theunderlying futures market settles at 95 on expiration day, both options expireworthless and you keep the entire $90 premium received. This is also the casefor settlement up to 105. For a settlement price of 86, the 95 strike put is worth9 (95 – 86 = 9) and the 105 strike call is worth zero, for a total spread value of9 (9 + 0), which is exactly what was received for the strangle. So 86 is the lowerbreakeven point; for any settlements on expiration day below 86 the short
FIGURE 9.10 Sell a strangle. The short strangle is similar to selling a straddle, but sellsoptions of differing strikes. The strategy still collects time decay on both sides of themarket, but with a wider proﬁt zone and a slightly lowered maximum potential proﬁt.
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strangle will lose money. The upper breakeven is calculated similarly and worksout to be 9 points above the upper strike price, or 114.
Trading a Breakout ViewJust as some options strategies are designed for a sideways-trending market,reversing the positions provides a way to trade a market that is expected tobreak out.Buy a Call, Buy a Put This is the inverse of the previous two strategies. Witha long straddle you buy both a call and a put with the same strike price, and with along strangle the options have different strikes. As expected, with these strategiesyou hope the market will move sharply in one direction or another. Perhaps theremay be an important report or event (like a Fed meeting) coming up, the outcomeof which might cause a sharp price movement in either direction, but you have nopreference whether the move will be up or down. Figure 9.11 shows the profit/lossprofile for the long straddle.Using as an example the same prices from the earlier short straddle example,we get the following plug-in-and-solve values. With both the call and put costing$60 each, the total investment for buying the straddle is $120. If the market pricesettles exactly at 100 on expiration day, both options expire worthless and you
FIGURE 9.11 Buy a straddle. By simultaneously buying both a call and a put, you seek amarket move in either direction. This long straddle is the inverse of the short straddle.
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lose the entire premium paid. Just as before, the lower breakeven point is 88 andthe upper breakeven is 112. Clearly, you hope to see the market move considerablyaway from the 100 strike price—and the further the better. Keep in mind that youdon’t have to hold any of the options strategies discussed in this chapter all theway until expiration day. Even a short-term move in the right direction can produce enough profit that you might choose to offset the trade.A long strangle is similar to a long straddle in that it is positioned for a breakout in either direction. The strangle is more affordable and therefore has lessmoney at risk. However, the market price has to move further to make your position profitable.Let’s now plug in and solve for values in the long strangle in Figure 9.12, usingas an example the same prices from the short strangle earlier. If the underlying futures market settles between 95 and 105 on expiration day, both options expireworthless and you lose the entire $90 premium paid. Just as with this strategy’s inverted cousin, the lower breakeven point is 86 and the upper breakeven is 114.
Other Options StrategiesAs you may have guessed by now, options can be combined to craft many otheruseful strategies, each with unique and fascinating properties. For instance, with abull call spread you could overwrite the short call side by selling two or more calls
FIGURE 9.12 Buy a strangle. This long strangle is the inverse of the short strangle. Bybuying a call and a put with different strikes, you tie up less money in the trade.
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in a strategy called a ratio write. Straddles and strangles can be turned into butterfly spreads.Strategies already discussed can be used in ways not shown here. For example, the short straddle and short strangle strategies can be done with strikes thatcreate a strong directional bias in the underlying futures. Legging into and leggingout of options can be an integral part of a strategy as well. For instance, in a variation on a bull call spread you can first buy the call side of the trade and then waitfor a rally before selling the higher-strike call. If you are able to get enough of arally, the higher-strike option can sometimes be sold for the same price that youpaid for the buy side, creating what is called a free trade.Follow-up strategies can be employed to readjust a position from time to time.For example, a short straddle or strangle can sometimes become skewed to an unfavorable directional bias. In such instances one leg of the spread could be rolledout to a further strike, or alternatively, additional out-of-the-money options couldbe added to the winning side to get the trade back closer to delta neutral.This section has covered only the more common and popular options strategies. Perhaps you’ll have established enough of an interest to explore the subjectin more detail. You may wish to visit the education tab of our web site, availableat www.lind-waldock.com, for periodic updates on a variety of options-relatedmaterials.
Are You Thinking Like an Options Trader?In this chapter you learned the distinctions of how to “think like an optionstrader.” Unlike other investment vehicles, options require you to consider not onlywhere a market is going, but also how it will get there. The reason is that optionsvalues involve not only market direction, but time decay and volatility as well.While the mechanics and terminology of options can be daunting at first, eachstrategy is actually very straightforward. It’s just that what options do can be verypowerful indeed, especially when done in combination strategies. Perhaps thebest way to understand and master each strategy is to plug in and solve for a variety of scenarios—the market is higher, lower, or unchanged on expiration day. Youcan also quickly estimate the effects of time decay by simply finding the amount oftime value remaining in any given week.Defining and controlling your risk can be two of the most important factors inachieving your goals as an investor, and options are perhaps the most flexible investment vehicle available for doing just that. With a foundation built upon thecontent of this chapter, you can consider options on futures as another valuableedge as you seek to achieve your investing goals.
CHAPTER 10
ForexAnother Opportunityfor Traders
I
n addition to the rapid growth of trading in the electronic stock index futuresmarkets, one of the hottest new trading venues in recent years has been the development of trading in cash currencies or the foreign exchange market (morecommonly known as the forex or just FX markets). With the prominent role of theU.S. dollar in the world forex market, in interest rates, and in the pricing of manyother markets such as gold, oil, grains, and soybeans, fluctuations in the value ofcurrencies against the dollar have provided attractive opportunities for traders fora number of years.The ability of individual traders to participate in this market has expandedgreatly with the establishment of a number of new cash forex firms since the late1990s, thanks to new regulations and advances in technology that make tradingand record keeping on a smaller scale possible. Some of these firms have many ofthe same regulatory requirements as futures and options brokerage firms. However, there are some important differences, particularly because cash forex firmsdo not trade on an exchange. Therefore, forex trading is worthy of a chapter of itsown in any book on trading.
WHAT IS THE FOREX MARKET?If the world existed with a single currency, there would be no need for a foreignexchange market. But that is not the case; most nations have their own nationalcurrencies.The forex market plays the key role of providing the mechanism for makingpayments across borders. It is the vehicle for transferring funds and purchasing167
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power from one currency to another and determining that all-important price, theexchange rate. Any nation whose residents conduct business abroad or engage infinancial transactions with persons in other countries must have a mechanism forproviding access to foreign currencies so that payments can be made in a form acceptable to both parties. In other words, there is a need for forex transactions—exchanging one currency for another. This is the forex market.Every successful market must have two key participants: those who want toeliminate risk and those who are willing to take on risk. Broadly speaking, theseare called hedgers and speculators. The financial institutions that facilitate transactions between these participants are called dealers. Dealers may be commercialbanks, merchant banks, investment banks, broker/dealer firms, or simply tradingcompanies specializing in foreign exchange.A hedger is a person or business that buys or sells goods, services, or investments denominated in a currency other than their native currency. Hedgers arelooking to offset the risk of fluctuating exchange rates so they can lock in the finaleconomic effect of a transaction.A speculator may be a bank, investment fund, trading company, or individual trader. Until recently, speculators in the cash forex market were largetraders; a retail market didn’t exist in any viable way. Now, however, technologyand regulation have created the opportunity for even small individual investorsto participate directly in the forex market. Here are some key features of thatmarket.
Birth of the Modern Forex MarketPrior to the early 1970s, the Bretton Woods accord, established in 1944, was thebasis for the international monetary system. The goal was to keep exchange ratesstable and provide for small adjustments by governments from time to time whennecessary. The U.S. dollar and gold were used as world financial reserves.The Bretton Woods system fell apart as a result of increasing U.S. balanceof-payments deficits and other countries’ reluctance to hold increasingly largequantities of U.S. dollars. Under the accord, the U.S. dollar was convertible intogold at $35 per ounce, meaning the United States had to take back its dollars inexchange for gold at a rate of $35 per ounce. By August 1971, the demand fromforeign central banks to exchange their dollars for gold became so great that theUnited States could not continue to honor this agreement. The so-called goldwindow was closed—the dollar was no longer convertible, and the U.S. dollarwas officially devalued.The subsequent Smithsonian Agreement realigned currencies and createdwider bands for fluctuation. This proved to be a useless attempt to perpetuate theadjustable peg system with a new currency alignment. The Smithsonian Agreement fell apart in February 1973, and other currencies were left to float againstthe dollar.Thus was born what has become the largest international trade and investment market in the world.
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Evolution of the Forex MarketA series of significant events helped to develop today’s forex market:1972—Chicago Mercantile Exchange (CME) introduces currency futures trading. Recognizing the significance of fluctuating exchange rates and theirpossible negative effects on international business, the exchange sought to providea marketplace for business to shift this risk to speculators. These were the first financial futures contracts, and they allowed individuals access to the forex market.1978—International Monetary Fund articles are officially amended,sanctioning floating exchange rates. Subsequently, the U.S. Federal Reserveshifted its policy away from targeting interest rates. In effect, this was the birth ofthe modern-day international fixed-income markets. Interest rates were allowed tofluctuate, thus creating large international money flows as investors soughtgreater returns on their assets.1985—The Plaza Accord. Demand for U.S. dollar investments had pushedthe value of the dollar to such levels that the Group of Major Industrial Nations(the United States, Britain, France, Germany, and Japan, known as the G5) worried about a so-called dollar bubble. The goal of the G5’s Plaza Accord was toachieve an orderly appreciation of the main nondollar currencies against the dollar. G5 countries cooperated in selling the U.S. dollar, precipitating a large decline.1987—The Louvre Accord. The U.S. dollar had lost more than 40 percent ofits value from the highs in 1985. There was general agreement among the G6 countries (the G5 countries and Canada) that current levels of their currencies werebroadly consistent with underlying fundamentals. They agreed to cooperateclosely to maintain stable exchange rates around those levels. This understandingamong the group of major central banks and finance ministers continues to be thebasis for cooperative central bank intervention in the marketplace.1992—Electronic trading begins. Globex, CME’s global electronic tradingsystem, began providing after-hours trading in currency futures.1999—Introduction of the euro. The euro began trading as the international currency of exchange for 11 countries in the European Union. It replacedthe deutsche mark, French franc, and Italian lira among others. The euro is progressively becoming more important as an international benchmark currency.2000—Commodity Modernization Act of 2000. After many years of debateamong the Federal Reserve, the Commodity Futures Trading Commission (CFTC),and the Securities and Exchange Commission (SEC), Congress officially definedthe retail forex marketplace in the United States, providing the definition of a retailinvestor and what types of institutions can deal with those retail investors. It alsoauthorized the CFTC as regulator of the retail forex marketplace. This has enabledU.S. forex dealers to open this market to retail investors and has led forex tradingto become the fastest-growing market segment of the U.S. investment community.
Largest and Most Liquid Market in the WorldWorldwide turnover is estimated at more than $1.8 trillion a day. Market liquidity istruly impressive. Large trades of $200 million or more are not uncommon. Likewise,
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FIGURE 10.1 Daily FX volume by currency pair, 2004. (Source of data: Bank forInternational Settlements)
small trades of $100,000 are also a staple of the market. Some currency pairs tradeseveral hundred billion dollars per day (see Figure 10.1). Yet studies have shownthat prices tend to move in relatively small increments, a sign of a smoothly functioning and liquid market.
A 24-Hour MarketWith the exception of weekends, the forex market follows the sun around theworld. Banks and other financial institutions provide continuous markets to theirclients around the clock via a network of branches, affiliates, correspondents, and24-hour trading desks.
International Network of DealersThe forex market consists of approximately 2,000 dealer institutions that are actively trading foreign exchange—trading with their customers and with eachother. Here is a simplistic view of a typical trade:Dealer A buys a foreign currency in exchange for U.S. dollars from Customer C.Dealer A then sells that currency to Dealer B.Dealer B then sells that currency to Customer D.
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In this manner, the risk of a fluctuating exchange rate has been shifted fromCustomer C to Customer D. The dealers have acted as the conduit and have provided the market to the customers.These dealer institutions are geographically dispersed, located in financialcenters around the globe (see Figure 10.2). Banks account for the largest share oftrading, but investment firms have become more active in recent years (see Figure10.3). All of these dealers are linked together by a progressively sophisticated electronic network of computers, telephones, and other electronic communicationssystems. The forex market is probably the only truly global market, linking thevarious foreign exchange trading centers around the world into a single, unified,cohesive worldwide market.
EXCHANGE RATES AND CENTRAL BANKSMarket forces of supply and demand determine exchange rates for the major currencies. Occasionally, central bank intervention influences prices, but this is donein a way that is consistent with free-market activity.Like any other buyer or seller in the market, a central bank is motivated to actbased on the economics with which it is faced. Central bank intervention is merelythe buying or selling of one currency against another conducted by the central
FIGURE 10.2 Estimated percentage of daily volume by ﬁnancial center, 2004.(Source of data: Bank for International Settlements)
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FIGURE 10.3 Daily global volume by counterparty type. (Source of data: Bank forInternational Settlements)
banks of one or more of the major industrialized countries. If exchange rates areinfluenced by a central bank’s activities, it is because that entity is injecting eithersupply or demand into the marketplace.In essence, that country has certain types of risk to mitigate. One way it attempts to do so is through forex market activities. But it doesn’t always work.Sometimes, the market forces that propel exchange rates in a certain directionare more powerful than can be overcome by even a group of central banks. Justbecause a government or governments want a currency to stay in a particularrange doesn’t mean it’s going to do so. Free-market forces determine exchangerates.
THE TRADING INSTRUMENTSince the breakdown of the Bretton Woods accord in the early 1970s, speculatorsand cross-border investment funds have conducted progressively more trading activity. This has been facilitated by the open-market policies adopted by the world’slargest economies, leading to a more global view of investments by most large investment funds and speculators who are the customers of dealers and generallydo not need or want actual delivery of the currencies that are traded. However,when a dealer trades with a commercial customer or when dealers trade with eachother, actual settlement of the transaction generally takes place.
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So what is actually traded? A foreign exchange dealer buying U.S. dollars isactually buying a dollar-denominated deposit in a bank located in the UnitedStates. This is the case even if the trade is conducted in Japan or any other financial center. Likewise, a dealer buying British pounds is actually buying apound deposit in a bank in Great Britain. The same scenario holds true for allforeign currencies.So, if Dealer A buys British pounds from Dealer B in exchange for U.S. dollars, the following takes place: Dealer A deposits the agreed amount of U.S. dollars into a bank account held by Dealer B in the United States (most likely inNew York). On the same day, Dealer B deposits the agreed amount of Britishpounds into a bank account held by Dealer A in Great Britain (most likely inLondon).The U.S. dollar is by far the most widely traded currency. In the 1998 survey offoreign exchange dealers conducted by the Bank for International Settlements, theU.S. dollar was estimated to be one of the two currencies involved in 87 percent ofglobal forex transactions.
Currency Pairs and Spot PricingForeign exchange rates are always quoted in terms of one currency against another. The two currencies involved in the transaction are called the “currencypair.” Most transactions involve a foreign currency exchanged for U.S. dollars—for example, USD/CHF (U.S. dollars versus Swiss francs). However, manytransactions occur as an exchange of one non-U.S. currency against anothernon-U.S. currency. An example of this would be EUR/JPY (euro versus Japaneseyen). Nondollar currency pairs are called “crosses,” and their exchange ratesare called “cross rates.”Most trading activity is done as spot transactions. Spot is a term used to describe the current market rate—the benchmark price. A spot transaction, by market convention, is a trade with a value date two business days after the date onwhich the trade is made. The two-day period provides time for the two parties toconfirm the agreement and arrange the settlement of the currencies into the specified bank accounts in the various international locations. An exception to this ruleis the currency pair USD/CAD (U.S. dollars versus Canadian dollars). Spot meansonly one day forward in this currency pair.Spot prices are quoted as a bid and an offer. The bid is the price at which themarket maker is willing to buy the base currency in exchange for the “terms” or“counter” currency. Because every forex transaction involves two currencies, it isimportant to keep straight which is the base currency and which is the terms orcounter currency. A trader always buys or sells a fixed amount of the base currency. The amount of the terms currency will vary as the exchange rate fluctuates.Another way of looking at it is that the base currency is always quoted as aquantity of the terms currency. So the exchange rate (spot rate) can be describedas the quantity of the terms currency that can be exchanged for one unit of the
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base currency. For example, USD/CHF means the quantity of Swiss francs neededto purchase one U.S. dollar.In oral and electronic communication, the base currency is always stated first,for example “dollar/swiss.” Bids and offers quoted by dealers are the prices atwhich they would either buy or sell the base currency in exchange for the termscurrency.
PipsA pip is the smallest amount by which an exchange rate normally changes. Formost currency pairs, this is the fourth decimal place. For example, if EUR/USD istraded at 1.2600 U.S. dollars per euro, a one-pip increase in the value of the eurowould make the exchange rate 1.2601. For certain currency pairs, a pip is definedas the second decimal place. These pairs involve currencies whose units are relatively small in absolute value, such as the Japanese yen.
RolloversBecause most speculative and investment customers of the forex market do notwant to make or take delivery of foreign currencies, the typical practice of mostdealers is to roll over their customers’ spot positions each day. There are two waysto do this.Traditional Method The rollover can be done in the traditional way of offsetting the position for the original value date and reinstituting the position forthe next spot date. The price differential between those two value dates islargely determined by the interest rate differential between the deposit rates ofthe two currencies.Depending on certain factors, this price differential may be in the customer’sfavor (he or she will earn the differential) or to his or her detriment (he or she willpay the differential). Generally speaking, if the interest rate of the base currency ishigher than the interest rate of the terms currency, forward value dates will bepriced at a discount to the nearer value dates. Conversely, if the interest rate of thebase currency is lower than the interest rate of the terms currency, forward valuedates will be priced at a premium to the nearer value dates.As an example, assume a customer is long 100,000 euros against U.S. dollars. Market convention is to quote euros as the base currency in terms of theamount of U.S. dollars it takes to exchange for one unit of euros. An exchangerate of 1.2600 means it takes 1.26 U.S. dollars to purchase one euro. Let’s alsoassume that the interest rate on euros is 2 percent while the interest rate on theU.S. dollar is 1 percent. When the dealer rolls the position forward one day, theforward-date price will be at a discount to the near-date price. Therefore, theclient will sell a position in euros on the near date and simultaneously buy back
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a position in euros at a discount for the one-day-forward date, thereby earningthe differential.Here is the formula for approximating this differential:[(Ti ÷ 360) – (Bi ÷ 360)] × Rwhere Ti = interest rate of the terms currencyBi = interest rate of the base currencyR = rate in number of units of the terms currency per unit of the basecurrencyIf the interest rate on short-term euro deposits were 2 percent, the interestrate on short-term U.S. dollar deposits 1 percent, and the spot rate for EUR/USD1.2600, the forward differential would be calculated as follows:1% ÷ 360 = 0.000027782% ÷ 360 = 0.000055560.00002778 – 0.00005556 = –0.00002778–0.00002778 × 1.26 = –0.00003500A pip value in EUR/USD is the fourth decimal place. So, given the precedingparameters, the nominal differential in a one-day EUR/USD rollover would be adiscount of 0.3