Option overlays in the forex are a great way to control risk while taking advantage of the upside in trading. Options are a broad subject so I only intend on discussing one concept in this article and then will follow up with another article on a second overlay strategy. The two concepts I will talk about are very common and can be executed easily and without constant maintenance. Those are two things I like to look for in a system so I am not the one making all the mistakes for the first time and so I can have a life along with my forex trading. I will cover protective puts in this report and covered calls next.
A put is an option with three components. The first is a contract. When you buy a put, you are buying the right to sell someone the underlying currency at a predetermined price for a predetermined period of time. You could buy a put today to sell a lot of the GBP/USD at 2.0000 any time between now and a date you choose in the future. If the currency pair falls to 1.9900, you can still sell it for 2.0000 and realize a profit. In fact, it doesn't matter how far the currency falls. If it is still within your time window, you can sell the currency for 2.0000 at will. The set price (2.0000) that you have selected for your contract is known as the strike price. The second component is time. Options are available in monthly increments. That means you can buy one that is good until next month or 12 months from now. The choice is up to you. Finally, options cost money. The price of an option is called the premium. The premium is higher the more valuable the options is. An option with a long time frame and a great strike price is more expensive than one with a very short time frame and a more speculative strike price. I think the best way to explain this is to use an example.
Let's assume that on January 22, 2007, you wanted to buy one contract of the GBP/USD. Let's assume it had a price of 1.9750. You are a prudent investor, and you want some protection from risk in the market so you buy a protective put that allows you to sell this contract at 1.9750 anytime before that contract expires. In this case, the contract would have expired a month later on the third Friday of February — the 16th. That put will cost you the equivalent of 150 pips per contract. The pair subsequently dropped to 1.9502. In that case, the put will still be worth 248 pips because you can still sell the lot for 1.9750 (1.9750 − 1.9502 = 0.0248). That is exactly equal to the amount you would have lost on the contract you were long so they wash each other out. In fact, the only thing you are out is the 150 pips you paid to purchase the contract in the first place. You didn't have to set a stop because you were totally protected. Even though the contract value dropped significantly-more than the 150 pips you had planned for you had a hedge that protected your capital.
The following month's trade, February to March, would have been another loss, but the March to April trade was a winner. For the March to April trade, you could have purchased the long position in the currency pair for 1.9372. You could have covered your position with a put at 1.9350 that would have cost you 120 pips, leaving you with some exposure between 1.9350 and 1.9372. However if you add those two positions, you had a level of total risk similar to what you had during the January to February trade. During the month, your long position rose significantly to 2.0027. That means you made 655 pips. What about your put? Well, there is no way you will want to sell this position for 1.9350 so you will just let the put expire worthless. That will reduce your gains by the amount you paid for the put so your new total is a net gain of 535 pips.
This strategy can appear to be slightly complicated at first, but it is worth learning more about it as it offers significant benefits. Institutional traders use option overlays, such as protective puts, all the time. It helps control risk and reduces total volatility in a portfolio. Here are a few more of the benefits, along with two of the cons, of this strategy.
You do not need to set a stop on your long currency position. How many times have you been right in your direction but got stopped out on a whipsaw in the market? I am positive that this happens to most forex traders on a regular basis. With a protective put, you are in charge and can let the exchange rate drop to zero, if that were possible, without exceeding your maximum loss. By the way, this benefit is also true during announcements. You are now in control.
Unlike many hedging strategies, this technique still allows for unlimited upside. Although gains are offset by the price of the put, gains can still be significant.
The total portfolio has lower volatility because your downside is capped. Here is an additional example. I will assume that pricing and volatility has been reasonably constant, on average, during the last 10 years and that your strategy is to buy a long position on the GBP/USD and an at the money put with total portfolio leverage of 20:1. That would have returned 10 percent per year during that period. When you combine this advantage with some prudent analysis, it is entirely possible to see much better returns than this.
The put will cost you 150 pips if you let it run until expiration each month-whether the market goes up or down. That price eats into your upside and creates a predetermined downside. Even if the market dropped less than 150 pips, the maximum loss will be the same.
If you purchase a put, you will pay a commission. With commission prices falling all the time, this is usually nominal but it adds another pip worth of losses to each month's trading.
The most difficult thing for most investors to do is to protect their capital. You will hear successful individual investors often say that if you can effectively protect your capital, profits will take care of themselves. I agree with that sentiment and use protective puts to help give me an edge.
by Jogn Jagerson, author of Profiting With Forex, a McGraw-Hill publication.