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. One of our trading
proftingWithForex.com uses option overlays, and you can follow along
month by month to see how this strategy actually performs in real time.
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
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
contract expires. In this case, the contract would have expired a month
later on the third Friday of February, the 16 th . That put will cost
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
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
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
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
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
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.
Benefit #1-No stops
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
Benefit #2-Unlimited upside
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
Benefit #3-Lower portfolio volatility
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
analysis, it is
entirely possible to see much better returns than this.
Con #1 — Cost of the put
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.
Con #2 — Cost of trading
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
sentiment and use protective puts to help give me an edge. At
ProfitingWithForex.com we maintain a model portfolio in the trades
section that uses option
overlays to illustrate the concept in real time. Log in, and check it
out to see what we are up to and what this looks like over time.
by Jogn Jagerson, author of Profiting With Forex, a McGraw-Hill publication.