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TRADER'S NOTEBOOK


Forex Options: Are They Really Exotic?

07/20/05 02:33:16 PM PST
by Rudy Teseo

Any similarity to actual security options is not coincidental...

"Exotic" — is it just a name for options? Or could it also be an acronym? Maybe something like, "Extremely Xtraordinary Options That Insure Compensation (or Commissions)." Whatever it means to you, "Exotic" is the name given to the five unique strategies available in the currency market. They may appear very complex when initially compared to the 20 or so standard strategies published by the CBOE, but a little study reveals that they are really quite simple. And, since there are only five, they can be memorized quite easily. As you will soon learn, they are aptly named -- the name describes the strategy. When we look at profit/loss curves, they won't seem strange at all.

FIXED RATE OPTIONS TRADING
Let's look at five option types that are considered "exotic:"

·Digital
·No-Touch
·One-Touch
·Double One-Touch, and
·Double No-Touch

Although there are slight differences between these five strategies, the premium you pay for each is determined by the selections you make for payout, strike price (barrier level), and expiration date.

Digital
If you believe the price of a currency pair will be above or below a certain level (called a barrier level) within a specific time period, you would select this strategy. Expecting a rally from the current price level, or a retracement, you would select the payout you desire, the strike price (barrier level), and the expiration date. The premium you pay is then determined by the selections you make. If the price is above or below the strike price at expiration, you receive the payout. If the price is below the upper barrier level, a call option would expire worthless. Similarly, if the price is above the lower barrier, a put option would expire worthless.

Your time frame determines the selections you make. For a short-term expiration, you might look at a couple weeks of history to observe the highs and lows of the period before selecting a barrier level. For a longer period, you would look at a month or two. Digital options are relatively cheap; typically, you could expect a payout of $1,000 with a premium of $100 ­ $200. That's a pretty good risk/reward! Of course, for this R/R, your time to expiration would be a matter of days, and the barrier would have to be considerably away from the current price. After all, the trader selling you this option is not looking to make you a gift.

Figure 1 is a typical order entry screen. Prior to this screen would be the screen in which you select the one of the five strategies you want to buy or sell. Having selected digital options, this screen shows that the premium for a $1,000 payout is $117.07.

Figure 1: Order entry screen.

Figure 2 shows a profit/loss curve showing the similarities between a security long call and a digital option. Both options start as a debit, which is the premium paid. The breakeven level for the call, above which the option is profitable, is like the barrier level for the digital option, above which the option is profitable. There is one big difference, however: with the security option, you must decide to sell or exercise before expiration. The digital option saves you a lot of monitoring, since your payout is immediately credited to your account as soon as the barrier is reached; this all applies equally to a digital put.

Figure 2: Digital option and security long call.

No-Touch
If the currency pair is trending, you might consider this strategy. This option pays a fixed amount (that you select) if the price never reaches (touches) the barrier level you select during the expiration period you select. The premium you pay is dependent upon your selections. The further out you set the expiration date, the higher will be the premium.

If the trend is up, you would select a barrier below the current price. You are in effect buying a call. Even though selecting a barrier below the current price seems bearish, you are betting that the price will continue to increase and never touch your barrier. Ergo: No touch. Conversely, if the current trend is down, you would select a barrier above the current price level. You are in effect buying a put. If the barrier is touched before expiration, the option expires worthless.

One-Touch
If you expect the currency pair is going to reverse a current position and test a support or resistance level, this strategy is a good one to play. This option pays a fixed amount if the price hits the barrier at least once prior to expiration. (You see: one touch.) Here, you would be guided by some technical indicator such as the Parabolic switching from long to short, or a Stochastic overbought or oversold indication. Again, you would select the currency pair, the payout you want, the barrier level, and the expiration date. If the barrier is not reached at least once during the option period, the option expires worthless.

Double-One-Touch
Unlike the first three strategies, which are entered as money makers, this one is a hedge position. If you are currently in a trading range position with an expected profit (as long as the market remains in a range), but are concerned that the market may turn volatile and breakout, this is your protection. Say you're hoping the range of 1.2100 and 1.2150 will be contained. You might buy a one-month double one-touch option with barriers of 1.2099 and 1.2151. If you expected to make $5,000 with the range trade, you might buy a $5,000 payout for $2,200 (for illustration only).

Now, if during the expiration period the price breaks out of either barrier, (double barriers, one touch) your payout would be $5,000. If there is no breakout before expiration, you lose your premium, but you still have the profit of your range trade. Your profit is $5,000, your risk $2,200 — a reward/risk better than 2:1. That's a good hedge.

Figure 3 is a profit/loss curve showing the similarity of this strategy to a security straddle. The major difference is that with the double-one touch-you're assured of $5,000 (minus the premium) in either direction, whereas with the straddle, the profit depends upon the direction the price takes and the difference between the call and put prices. Again, you have to make decisions with the straddle, whereas the double-one-touch option pays immediately.

Figure 3: Double-one-touch and a security straddle.

Double-No-Touch
This is another hedge position. This strategy is best if you are playing a currency pair with the expectation of a breakout above 8290 or below 8280, but want to protect yourself against the pair becoming range-bound. In this scenario, you would buy a one-month double-no-touch option with barriers of 8290 and 8280. You then select a payout equal to your expected profit from your current position.

If either barrier is breached at any time before expiration, your premium expires worthless, but you have the profit from your breakout. If neither barrier is touched (double barriers, no touch) you are immediately credited with the payout.

For all of these "exotic" options, as with every new strategy or technique, it is advisable to open a demo account and practice often until you're entirely comfortable. If you have never traded multi-leg security options, then perhaps some additional study would be prudent.

Rudy Teseo is a private investor and currency trader, and has taught classes in option trading and technical analysis. He can be reached at RFTESS@Juno.com.

SUGGESTED READING
Chambers, Clem [2005]. "From Plain Vanilla To Exotic: So Many Options!" Working Money, May 27.
Teseo, Rudy [2005]. "Forex Risk Management," Working Money, June 29.
__________ [2003]. "Profit/Loss Curves," Working Money, April 1.

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.



Rudy Teseo

Rudy Teseo is a private investor who trades stocks, options, and currencies. He has taught classes in technical analysis and option trading. He may be reached at rftess@optonline.net.

E-mail address: rftess@optonline.net


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