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OPTIONS TRADING STRATEGIES
BUYING EUR/USD PUT OPTIONS
All of the popular foreign currency pairs can be traded in the futures and options markets.
For example, let's say that you are bearish on EUR/USD, meaning the Euro-U.S. dollar exchange rate.
The EURO/USD exchange rate is the price of one Euro in U.S. dollars. To be bearish means that you expect
this rate to fall, in other words, that you expect the Euro to weaken against the U.S. dollar or,
alternatively, the U.S. dollar to strengthen against the Euro. You are watching the March 2010 EUR/USD futures
and expect prices to retreat sharply from heavy resistance at the $1.5000 level and to move lower over the next few months. (See chart at right.)
To profit should this happen, you are considering buying a put option on the EUR/USD futures.
The first step of the
purchase decision
is to determine the maturity of the put option: it must be long enough to capture the anticipated price drop.
Since you suspect that prices will move lower over the next several months,
you decide that the
March 2010 EUR/USD call options that
expire in
early February
are a good choice. The second step is determining the strike price.
March EUR/USD put options are available across a wide range of strike prices, each having a different cost.
(See table at right.)
Reading EUR/USD Option Prices
EUR/USD options are priced
in dollars per Euro up to four decimals. One EUR/USD option can be exercised into one
EUR/USD futures contract and since each contract is based on 125,000 Euro, the option price must be
multiplied by 125,000 to get a corresponding dollar value and every one cent change in the price of the option or the underlying
futures for that matter is worth $1,250 per contract.
For example, the March EUR/USD put option struck at 1495 (or $1.4950 per Euro) settled at 0.03930 meaning $0.0393 per Euro.
The dollar value of this option is $0.0393 x 125,000 = $4,912.50. This put option is at-the-money
since the March futures contract settled the day at $1.4961 per Euro. Notice that the futures closed
higher over the day by $0.0118 pushing all put option prices lower but that the option prices moved by less
than this amount. In fact, this at-the-money put option fell by just $0.0068 per Euro.
As is evident in the table, as the strike price of a put option is raised,
its price increases
as does its sensitivity
to movements in the price of the underlying futures.
Choosing the Strike Price
This requires balancing risk with potential return. The former is simply the cost or purchase price of the option
along with brokerage commission and other trading fees. For example, if you want to risk at most no more than $2,500
on a March EUR/USD put option, then only those options having a strike price of 1440 (or $1.4400 per Euro) or lower would be acceptable.
The potential return is based upon your expectation of how far EUR/USD prices will fall. A useful reference is the
break-even price.
The break-even price of a put option
is calculated by subtracting the option cost and paid trading fees from the strike price.
Consider, for example, the March EUR/USD put option struck at 1480 (or $1.4800 per Euro). If it is purchased at
the settlement price shown, then the break-even
price of the March futures at option expiration is calculated as:
1.4800 - 0.0327 - fee value = 1.4473 - fee value.
At option expiration, March EUR/USD futures must be below this break-even price in order to
profit on the option trade.
So, you will only consider put options that have a break-even price above the price to which you expect
EUR/USD will fall. Let's say, for example, that you believe March EUR/USD can drop to $1.4200 per Euro by option expiration
which is an area of support seen in the chart above.
Based on this, you would only consider buying put options having a strike price of 1445 (or $1.4450 per Euro) or higher since otherwise the break-even price
is too low.
What remains is the range of acceptable options. In this case, for an investment of at most $2,500 and with an expectation that March
EUR/USD will fall to $1.4200 per Euro by option expiration, there are no acceptable put options to purchase. So, you
can consider buying a more expensive put option and manage the risk, or
you can consider buying a bear put spread.
Bear Put Spread
When buying a bear put spread, both strike prices should be above the price to which
you anticipate the futures will fall by the time the options expire, in this case, $1.4200 per Euro. Based on this, there are several spreads
that can be purchased. For example, the 1430/1440 bear put spread has a value of 0.0197 - 0.0173 = 0.0024 = $300 plus commission and fees.
If March EUR/USD futures is below $1.4300 per Euro at the time of option expiration, then this spread will close
at its maximum value of $1,250 (calculated as one cent x $1,250 per cent). If EUR/USD is above $1.4400 per Euro, then this spread will
expire worthless.
Stepping up the strike prices will increase marginally the cost of the spread, but the chance of the maximum value
being earned is greater since EUR/USD need not fall so far. For example, the 1440/1450 bear put spread has a value
of 0.0224 - 0.0197 = 0.0027 = $337.50 plus commission and fees. March EUR/USD need only fall below $1.4400 per Euro at the time of option expiration
to earn the $1,250 maximum value of the spread. If EUR/USD is above $1.4500 per Euro, then this spread will expire worthless.
As you can see, spreads can be constructed at relatively little expense. You can risk more on a spread in return for greater
potential payout by increasing the gap between the two strike prices. For example, the 1430/1450
bear put spread has a value of 0.0224 - 0.0173 = 0.0051 = $637.50 plus commission and fees but the maximum value is $2,500
and will be earned if March EUR/USD futures is below $1.4300 per Euro at the time of option expiration.
Because the market for option spreads is generally less active than the market for individual options,
you will likely have to pay a slightly higher price in order to effect the purchase. After the purchase,
you will need to manage the option spread position.
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March 2010 EUR/USD Futures
Settle on Nov 23, 2009: $1.4961 Change: +$0.0118
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March 2010 EUR/USD Put Option Prices
Prices as of Nov 23, 2009. Source: CME Group
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Test your skill at trading EUR/USD options in a futures and options paper trading account.
Staffed by salaried, not commission personnel, you'll speak directly with a futures professional who will
provide any educational support that you may need. Click image above for more information.
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