Krugman's Forex Castling Strategies

Trading Systems Free Forex Trading Systems
1

[B]Forex Castling(Forex Derivative Hedging)[/B]

[B]What is Castling[/B]
Castling is a basket of trading methods that involve using various option/ETF strategies to help hedge against losses while maximize profits from winning positions. Castling is a term derived from the game of chess, where a king or queen piece can be swapped with a rook. Many times this move is used as a defensive strategy, but in some cases can be used as an offensive strategy. In Forex castling we take Forex positions and used currency correlations with various ETFs to create protective hedging. There are dozens of various Forex castling strategies that can be used depending on the trading scenario, as well as the traders risk appetite. Each strategy has its own unique application.

[B]Why Use Castling[/B]
The trading strategies I will be discussing are widely used by banks, hedge funds and successful millionaire traders. I take many popular option trading strategies and use both the correlation and leverage characteristics of options/ETFs to create effective Forex/Option trading strategies. In the world of stock trading, options strategies can be used to protect against sudden movements of an underlying security or can be used for the purpose of speculation and making profits. I will approach both strategies and how they can be applied to Forex trading.

Many know me for teaching Price Action Forex trading techniques that apply to both daily and intra-day trading. Along my trading/teaching journey I have found that while some people thrive and excel at trading these time frames, others struggle. I believe this is a good strategy for those struggling with trading daily/intra day setups, overtrading, find price action confusing or overwhelming or for those who simply want to diversify their trading. While each castling strategy has its own learning curve, they are very much rule based and once learned can be implemented over and over fairly quickly.

[B]This Threads Focus[/B]
This thread will solely focus on the various castling techniques that I have created and walk through the step by step process of implementing these strategies. I will also be posting forward testing of various trades to see the practical implications of each strategy. Also if you see benefit in this type of trading and are going to be doing your own demo or live testing, please post your trades here with full analysis as that will bring HUGE benefit to this thread! If you aren’t sure if a post you want to write falls within the thread boundaries, just shoot me a quick PM and I will let you know.

[B]What This Thread Won’t Focus On[/B]
There are a lot of things I could list here, but to keep it really simple I will lay out some of the most common off topic discussions that won’t be allowed here. First we will not be discussing trade entry techniques. Whether you use price action, stochastics/MACD/EMAs, volume spread analysis, support and resistance, news and fundamentals, or any other type of trading method, these castling strategies work. Secondly this is not the place to discuss brokers. Castling requires both a Forex broker and an options broker. I personally use FXCM as my Forex broker and Options House as my options/stock broker. There are a billion threads that exist for brokers, if you have questions then please use due diligence and search out the answers to your questions outside of this thread.

[B]About Me[/B]
I started out my trading journey in the world of options trading. I have always enjoying trading stock and options and learning the various strategies that can be applied to different trading scenarios. The most attractive quality of options strategies is that it lets the trader choose a strategy out of a large basket of strategies, the one that best applies to their trade setup. I use these same multi strategy principles in my price action trading thread. Castling is a way to take the large basket of options strategies and bring it into the world of Forex trading. My unique background in stock and Forex trading has helped me take strategies that have historically been applied to only to the stock market and recreate them in a way that they can be successfully applied to the Forex market.

If you would like to learn more about me please check out my complete bio here.

[B]Conclusion[/B]
I believe that most of the successful traders with long term sustainability have two main trading characteristics; one is that their trading has diversity. This means they don’t rely on a single strategy or even a single market to risk all of their capital on. The second characteristic is that they have strategies to help minimize losses. One of the main reasons that option trading has become so popular is because it has opened the door to a large number of trading techniques that allowed for minimization of losses, without sacrificing much profit. I want to shed light on the potential profitability of trading longer term, and how applying castling techniques to this type of trading can help minimize risk.

I have not yet used this in my own Forex trading as I primarily focus on lower time frame price action trading. I do plan on incorporating this into my trading to diversify my own trading. I have never seen it discussed or applied to forex trading so as far as I understand, this is new to the world of Forex, at least in the sense that it has been written out in a learning format for others. These strategies are popular and commonly used with success in the stock world, and the same sound principles can be applied to Forex trading strategies.

[B]Thread Requirements[/B]

[B]Time Frames[/B]
Most trades will be held for anywhere from a couple weeks up to a couple months. Depending on what strategy you are looking to use will determine how long you want/need to hold a position. What chart time frame you enter from will vary, but for long term trades we will mostly be looking at the weekly and monthly trends of a given currency pair.

[B]Capital[/B]
Because many of these strategies will require holding a currency position, stock option and shares of an ETF, You will want a minimum of $2,000 – $5,000. Remember though that these are long term positions and some of your capital will be used to hedge your currency positions, so the risk for your entire trading capital will be relatively low. How much capital you need will primarily depend on the leverage you have and the castling strategy you use. While this may seem like a lot for some, many traders will blow up small accounts many times over. Instead of losing small amounts of money quickly with high frequency trading, we want to take a larger sum and create a strategy that will make solid gains for us in the long term.

[B]Platforms[/B]
You will need a Forex broker and an Option Broker. I use FXCM(for Forex) and Options House(For stock and options) as I have found these to be the best brokers with the smallest fees. Whatever brokers you use, you will need a Forex broker and a stock market broker that allows options trading.

[B]Who can do it?[/B]
Anyone who already implements a medium-long term trading strategy can improve his/her trading performance with these option techniques. These strategies aren’t for learning how to enter trades, but rather improve a current technique. There are some very simple and effective long term trading techniques that exist. Each castling technique will have its own difficulty curve with some being simple to learn and implement, and others being more complex. Once they are learned though the strategy can be applied over and over with no new learning required. These strategies are rule based which helps make them easy to implement in your own trading. Essentially anyone already trading Forex can implement these castling strategies.

2

[B]Terminology[/B]

[B]Partial[/B] - Only one currency in the pair is hedged
[B]Full[/B] - Both currencies in the pair are hedged
[B]Unsecured[/B] - The held position is not producing positive rollover and the premium of the option strategy is not being offset
[B]Secured[/B] - The held position is producing positive rollover to help offset the premium of the option strategy
[B]Protective Put[/B] - A castling strategy where a strongly correlated put option is purchased on a currency short as a hedging strategy
[B]Protective Call[/B] - A castling strategy where a strongly correlated call option is purchased on a currency short as a hedging strategy
[B]Protective Put[/B] - A castling strategy where a strongly correlated put option is purchased on a currency long as a hedging strategy

3

*Reserved

4

*Reserved

5

hi. Krugman:
nice to see your new thread. I’ve been following your threads about ‘price action’ and ‘EA’ with great interest. looking forward to contributing to this one as well!
just one concern: I’ve only been trading ‘price action’ Forex and never really dive into stock and option trading. Is that a problem? can I still learn this technique?

6

Hey zhangshuo, thanks for dropping by! As a programmer, EA’s are something I play around with for fun, but my primary method of trading is price action trading the short and medium term charts. This will be an approach to long term trading, probably also using key S/R level and price action, but also combined with the castling strategies. These castling strategies won’t work very well on short-medium term trades.

In regards to if you need to know or understand the stock market, the answer is no. Actually it won’t even matter what is happening in the options we are buying. With some of these strategies you will be buying options that have heavy positive or negative correlation to a certain currency. For example gold has a strong positive correlation to the Aussie, so we know that when the Ausiie goes up then gold will go up. All you will need to know is how to trade Forex, what commodity or ETF is strongly correlated to your currency pair, and what castling strategy you want to implement. With the assumption you already have a long term trading method, the correlation and strategies will be discussed here.

Note: There are reverse castling strategies where you can primarily trade ETFs and Futures and use highly leveraged currency baskets to hedge your market trading, in which case you would need to know much more about how to trade ETFs and Options. In this thread the discussed strategies will only involve options being used as a derivative hedge for a currency position held by the trader, and the options purchased will be based on the strategy rules.

7

hi, krugman, thx for your reply. I am already trading Forex using price action. So based on what you said above (correct me if I’m wrong), I am going to be trading Forex using correlation and castling strategies (of options market) in the realm of this thread?

8

Yes, you are correct. This thread will look at the various strategies of hedging your positions using stock options that correlate strongly with whatever currencies are in your basket.

9

Ill be taking a look here regularly Aaron, interested to see where the thread heads.
Dont know how much input I will have, still very new to price action and medium term trading

10

Very interesting subject Aaron and i am looking forward to reading all about it. Right now i have a lot on my plate but from next year that will hopefully change. I also like to read everything at once to get the big picutre so i will wait until you have gathered more information in here. But be assured that i will follow this thread with big interest and hopefully also have enough time to contribute.

11

I wanted to lay out in theory the idea of the [B]Protective Call[/B]. The idea behind most of these strategies is purchasing “short term insurance” that will cover the cost of your losses. This could essentially allow you to invest a far greater amount of capital in your trades without the risk of losing all of it. Lets say you trade with 10,000$ right now and generally risk 1-2%. Using castling strategies you may be able to risk in the neighborhood of 5-10% of your capital while still only having 1-2% of it actually at risk. Just thinking being able to make 5-10x your regular profits without risking any more, and in some cases having even less at risk.

Let me compare Castling to an every day topic. Lets say you never drive a car, but for just 1 week this year you are going to take a major roadtrip. Would it make sense to buy a years worth or even a months worth of insurance for a week or less of driving? What if the insurance cost more than the vehicle itself? Now imagine if you could insure only the days you are driving, so you are still getting full coverage benefits while only paying a tiny amount for the days you are using it. While that doesn’t work in real life, the markets have developed in a way we can do this for trading!

[B]How options work[/B]
The way a protective call works is that when you are shorting a currency, you can buy that “short term insurance” by hedging your positions with a call option that is strongly correlated with your currency positions. The way call options work is that you purchase an option you aren’t actually purchasing the shares of the stock, but rather the right to buy the stock at whatever price is on the contract. The great thing about an option is that you don’t have to pay the price of the shares, only the cost of the option. I can purchase call contracts that represent $100,000 worth of currency, while only paying a few 100$. The crazier thing is that when the price of the stock goes up my contracts will go up at a rate close to the stocks. I.E. if I buy calls that represent 1000 shares of XYZ company and XYZ is worth $100 a share, while 1000 shares cost $100,000, my contracts may only cost $2,000. If the price of XYZ goes up to $150, my contracts my move up 75% of that or 0.75 a share. That means my contract are now worth $2,000 + ((.75 *50) * 1,000) or almost $40,000. This behaves a lot like the leverage you see in Forex. It was not uncomming during the gold boom for gold contracts to increase 1000% a day. One thing I didn’t mention is that a contract represent 100 shares of a stock. So if your contract has a 75% correlation with the stock price(like in the example about), if the stock goes up 10% then theoretically your contract will go up ((10 * .75) * 100).

[B]How Protective Calls Work[/B]
Understanding all of the above isn’t required to use castling, but it is good to get a thorough understanding of the insurance you will be purchasing for your Forex positions. How a protective call works is that while you are holding a short Forex position, you will purchase option calls from a stock with strong correlation to that Forex pair. If you short the AUDUSD, and you have $1,000 at risk you would need to buy enough call options that if your forex position ended up losing, your options contract would have made $1,000 essentially creating a break even scenario. There is only 1 way to lose in this strategy and that is the time premium of the options. Options have expiration dates, the longer you hold the option the more it loses value. This means the longer you hold your “insurance” the more it costs you. This cost called [B]option decay[/B] is very small compared to the amount of money it is insuring. It may cost you 50-100$ to insure a 1000$ risk for 2 weeks. This means you enter a position and after holding it for 2 weeks it finally gets stopped out, while your Forex account lost $1,000, your option contracts made $1,000, and all you are out are the broker fees and whatever decay may have happened in the two weeks. This is why you as a trader can invest much larger %'s of capital into your trades, while ensuring not all of that capital can actually be lost. What if the position is a winner? If your Forex position is winning that means your contracts are losing. What that means is that you will have to dip into your winnings to pay for the insurance. If you risked 1,000$ and you may a 1:3 RR, you made $3,000. In that time your contract may have lost %50 of their value or $5000. So you have a net increase of $2,500. You may say “Well that’s a crappy deal that I lost 500$”. But without the protection of castling, you would not be risking nearly as much, so your overall winners would be much smaller without it. If you risk 1,000 with castling that may represent a 10% risk of your capital, without castling you may only want to risk 100-200%, in which case a 1:3 would have only made you $600-$800 . Contract can be bought and sold on a daily basis, so you can purchase your full insurance and as soon as your take profit or stop loss is hit, sell your insurance and get back the difference. The most you could possibly lose in the above scenario is $1,000. That would mean if your Forex position didn’t move for the entire length of the contract, and the contract expired worthless. But you are still essentially insuring your positions without risking anymore than if you were to take the position without an option hedge, pretty cool huh?

I will try and post more visual aids to explain this more. It will take a few posts to really dig in. I hope this wasn’t information overload for everyone, but I wanted to start with a protective put as this is the most simple castling strategy you can do. While this may seem weird or too good to be true, this is exactly what big time investors do to protect their downside. There are even strategies that involve only buying and selling options contracts. I believe one of the reasons mainstreet traders don’t succeed is because they aren’t informed of the various protection techniques and thus put themselves at much larger risk of loss than the “big guys”.

12

Fantastic thread idea and credit to you for having the creativity to adapt this to forex trading.

As you know am trading daily charts for forex and I am wondering can you give me an estimate for the shortest time period (ie in terms of how long a trade is open for) for which you think these castling strategies would work?

And if you have to close a trade out quickly say because of market conditions or for whatever reasons, does that mean you would lose more by having used one of these castling strategies? Apologies in advance if these questions don’t make sense but I am a total newbie to this and am just trying to get the concept straight in my mind.

Cheers,

13

These are great questions and ones I have been thinking through myself for a while now. I am reconsidering my idea that this won’t work on short to medium term trades. Now that I have been working through some of the numbers, the shorter the trade is the better, as this means your options accrue less decay, and you can sell them back into the stock market close to what you bought them for. The effectiveness of castling strategies aren’t really in the amount of time your trade is held, but rather how much movement you are looking for or how large your stoploss is. I think castling strategies begin working when your stoploss is 1% or larger of the pair you are trading. For the EURUSD that is around 140 pips(1.3700 * .01). You usually don’t have 1% length stop losses until you get into the daily charts. So I think daily and up will be perfect for this type of hedging strategy. The reason for 1% is because you need enough distance for the stock option to move and hedge your position. To summarize, the faster your stoploss or take profit is hit, the less money will be spent on decay from holding options. The timeframe the trade is taken won’t matter as long as your trade is large enough to cover a decent distance, around 1% minimum for SL distance(You will need your take profits to be large enough to pay off the hedge and profit from the position also, around 1:2 should be a minimum).

I am not sure I understand what you mean by closing out a trade because of market conditions. If I am thinking of your question correctly you are talking about potential reversals or big news events. In which case these things won’t be nearly as big of a deal anymore. To simplify the idea of Castling,basically if you position loses money your hedge make profit at the same rate, so you have a net loss of $0. If your position is wins, you will sell your hedge back to the market, take a small loss on the hedge and pocket the rest of the profits.

There are three interesting thoughts with Castling. One is a more advanced topic of stock options, which is when volatility increases the value(and price) of options increase also. Sometimes options will more than double in price just because volatility picks up. This means that you may actually end up making money from a losing Forex position. I.E. If you are going to trade a breakout, and you guess the wrong direction then your options are increasing in value as your Forex position is losing, but the volatility from the breakout causes all of your options to also increase it’s value. There are scenarios where the profits from your hedge can outdo the losses from your Forex position.

The second interesting thought is that hedging almost removes the need for stop losses or at least allows the trader to widen his stop losses to greatly increase his trades chance of success. If you have a hedge that begins making money at the same rate your position is losing, then in theory you will have a net loss of 0 no matter how far negative your position goes. Reality is that the market isn’t that perfect but it is quite common to no have stop losses in stock trading or have stop losses of 10-20% of the overall stock price because if you hedge your positions correctly then you are making money on your hedge while your position losses, greatly decreasing the effect from the loss. A 10-20% stop loss on the EURUSD would about like 1300-2600 pips, haha.

The third thought has to do with “secured” castling. This means that the rollover from holding a position either covers part or all of the cost of hedging. Secured castling may be one of the biggest goldmines to yet be tapped in Forex trading. A variation of this is common in stock trading. A trader will get dividends from his stocks and use that money to hedge his positions, so the trader is able to pay for his hedge with reoccurring profit from dividend payments. This is very similar to purchasing and holding a hedge using Forex rollover. If the rollover is equal to or greater than the cost of the decay of holding a hedge, that means your hedge makes up the losses of the position, and the rollover covers the cost of the decay of holding options, so you have literally zero risk and zero expense to your losses, and your profit is unlimited. Obviously in the case of a secured hedge, the length of holding a contract is less important because it’s cost is covered by the rollover. There is great potential in both secured and unsecured castling strategies. I hope to get some good visual illustrations to make it easier to understand.

14

Here is a graphic representation of how the profit loss curve of the protective call fits with the profit/loss of the Forex position. The graph takes into account spread and broker fees which is why the options are in a loss when the trade is opened. It doesn’t take into account time decay because that will depend on how long your position is open(which is an unknown variable) and also will change depending if the hedge is secure or unsecured(rollover to cover the cost of the castling strategy). You break even once your Forex position has made enough profits to cover the spread,broker fees and lost value of the hedge. If your Forex position is winning, the options won’t lose value at a very fast rate, you can see that they gain value much faster than they lose. The reason for this is because when you buy an option that is “At The Money”, once your option falls out of the money it loses value slower and slower, if your option goes deeper in profit, it will accelerate, which explains the option curve.

Options Graph Protective Call.jpg700×470 29.7 KB

15

yes, correct - I was asking in the context of you having said that you need to be able to hold the trade long enough for this to be of benefit - ie presumably if your stop gets hit quickly, then the hedge is not as efficient, hence double whammy of downside. But since you now think this strategy would work equally well (if not better) with shorter term trades, my question is not longer relevant.

In any case, the information on this you have put out so far is extremely interesting and has huge potential. I would like to take some time to think out the potential uses for the strategy and its permutations for myself…but I’ll be back to contribute/ask questions…Thanks. :slight_smile:

16

Hello captain, i’ve been following you closely for quite some time now and i can see your hardwork and wealth of experience in trading.
This castling method looks great and am hungry for more. Please keep it coming coz i and others are anxiously waiting for more.
Thanks man, for your kindness.

17

I have a question though captain,
as regards this method it seems as a trade is being considered on a forex pair, same is also considered in an option or future. Will this happen same time or at different times?
For forex traders like myself who has no knowledge of stocks, option and futures, can will still apply this method?

18

Hi Aaron,

One quick question I have thought of - how likely is it that the correlation between the forex pair and the stock stops working - ie eurusd and usdchf are negatively correlated but on some occasions they trend in the same direction…in such circumstance then the hedge would not work and you would double your losses (I guess you wouldnt double your profits though as the call option only triggers if the stop gets hit???).

Again, just trying to get my head around this, I may be operating from completely the wrong assumptions, so I hope my questions make sense.

Thanks.

19

I am glad you have been enjoying the material I have been putting out there. I am really excited about the potential of this strategy and will keep putting out information as I study this out more. Right now I know the theory and math behind some of these strategies so I am looking into ETFs that have good correlation with certain Forex pairs, and see if the option prices move with the currencies. Once I find some good combinations and have them tested I will write out a thorough analysis and maybe even a good video tutorial on it.

20

This is a great question, and something I could see many people wondering or being concerned about. I plan on this being very step by step and methodical, and requiring little or no prior knowledge of options to use. It would look something like this, for each lot of AUDUSD shorted, buy 20 GLD puts. I am going to have it formulated out to where I have found ETFs that correlate best with each currency pair and how many options contracts you need to purchase for a given amount of currency. All you will need to do as the trader is then purchase the options, which is similar to purchasing currency.