Using options with fx?

Hi all,

I was wondering whether anyone here on babypips uses options to minimise the downside risk when trading FX. For example if you went long then you could buy a put option to minimise losses.

The problem I have found is that preferable fx brokers do not provide options or any other fancy financial creations. Therefore, it is hard to keep track of all the numbers if using different brokers.

I would be interested to hear from anyone who successfully manages to do so.

Please, share your thoughts!
Thanks

Hi,

A very good question the answer to which may interest some.

First let me say: I don’t do this so I’m not talking from experience. However: I’ve done extensive reading over the years on the matter.

As a matter of fact: I was quite surprised to find an email in my inbox just the other day from none other than a chap by the name of ‘Norman Hallet’ (he’s pretty well known) where he was advocating (or should I say ‘suggesting’) that FOREX traders look seriously to ‘Binary Options’ for this purpose. The problem, so far as I can tell (and have been quite vocal about this on another thread) is that most of the Binary Options Brokers appear to be rather ‘dubious’ and therein lies ONE problem so just be careful is all.

Of course (and once again probably ‘shooting myself in the foot here’ given WHO I am and WHO I represent): I know that IG Markets and a place called ETX Capital offer options (Binary and ‘normal’ for want of a better word). Unfortunately Deltastock does not offer options of any kind so there’s no point in my trying to do a ‘hard Deltastock sell’ to you i.e. but I can try to help is all.

Just check out the reviews on Forex Peace Army (forexpeacearmy.com) is all i.e. IG Markets has some ‘less than stellar’ reviews by quite a few traders. ETX Capital (extcapital.com or etxcapital.co.uk), for some or the other reason, isn’t even listed on Forex Peace Army but they DID win some or the other award last year from Trade2Win. Binary Options, by the way, and at a good broker anyway, and as I understand them, are nothing other than ‘normal’ ‘Vanilla’ Options really.

I believe it to be a viable (and professional) ‘practice’ (not just with FOREX). The only thing I’ve never been able to QUITE figure out is how to justify the cost of the option. In other words: how do you ‘balance’ the cost of the option against the potential profit / loss on the spot (directional trade) position. In other words: let’s say that your ‘normal’ trade is profitable. This would mean that your (let’s call it a ‘protective’ or ‘risk management’ option) will expire ‘out of the money’. In this case of course: the last thing you want is for the cost of the option that has expired ‘out of the money’ to exceed the profit made on the ‘normal’ trade. Maybe somebody that knows more on this subject could ‘chime in’ here???

But suffice to say: it is indeed a valid trading strategy from what I gather. I think that you just have to get your ‘sums’ right is all.

Sorry I cannot be of more SPECIFIC help but hopefully this will spark some ‘debate’ on the subject.

Of course: there’s another ‘option’ (no pun intended) and that is to trade the ‘spot’ against the currency future (I’ll try and ‘dig up’ a link that I know that I have somewhere from Investopedia on the subject). The basic idea really is that the ‘spot’ price will always (well ALMOST always) differ from the currency futures price so you’re in fact ‘hedging’ the spot price against the currency futures contract and hoping to ‘pocket the difference’.

Of course no matter which way you try to to it: minimizing risk will always come at a cost to a profitable trade i.e. if the profitable (original trade) is profitable the cost of the ‘protection’ needs to subtraced from such profit.

Regards,

Dale.

A great post Dale, thanks!

Hopefully someone with previous experience of minimising downside risk will be able to chip in. For one thing, I know banks often use options to minimise their risk. So if we have any ex bankers they might be able to offer some advise hopefully!

In the mean time I’ll take a look at the brokers you’ve mentioned.

Indeed, I have always wondered how the cost of these instruments will affect overall p/l and whether they would actually be a viable solution to mitigate the risk.

I’m a great believer in keeping it simple, I really don’t see the point of hedging, I mean why not reduce your risk through money management as opposed to hedging.

Consider that you may even be increasing your risk by hedging, since you are bringing an extra dimension and hence another risk into your trade, I always reduce risk by choosing the best setups and concentrating on the one trade setup in hand.

I would agree to an extent, there should be no problem making money if you have a sound plan and good money management.
I was just interested to see if people did use options to hedge as it seems a perfectly good hedging tool (given the big boys use them) providing low option cost etc.
However, I don’t think there are any retail brokers that have platforms that let you trade fx (not spread bet on fx) and also buy options apart from saxobank, but they have horrendous reviews and you need a fair chunk of cash to start with (which I don’t). Otherwise its just the professionals bloomberg/reuters etc

Good (Sunday) morning all.

I have to say that I’m with purplepatchforex on this one BUT let me qualify that statement i.e. I’ve never really done any real research on the subject as I noted so I’m not talking from an edcucated point of view here.

The closest I’ve come (as I noted) was to ‘mess about’ with Binary Option Demos and I can just see the possible pitfalls ‘a mile away’ with all the brokers I looked at (they usually have a picture of a ‘not too shabby looking’ ‘chicky-boo’ ‘promising’ you some type of astromical gain in ‘less than an hour’ and that type of thing and with all of them their little ‘tick charts’ look ‘suspect’ at best and I could go on about this. Even with the demos there were problems which, when queried, no satisfactory answers were given (like a Binary Option that had it closed ON TIME it would have expired in the money but due to a forty-five second delay in closing it ‘as if by magic’ expired out of the money and this happened MORE than once at different brokers so that already tells me without even investigating further that these things, broker dependant, are easily manipulated. One other warning sign that I found was a lot of these Binary Options Brokers, last year anyway, ‘did away with’ the ‘One Touch Options’ for the simple reason, in my opinion, that anybody that can recognise a short-term trend in one direction or another on a ‘normal’ fifteen minute chart could NOT ‘go wrong’ but I see some of those same brokers have brought them back now and I’ve not bothered to test them out again).

But alright: I’ve digressed a bit (as usual) in talking about (very short-term) Binary Options. It IS, however, intersting to note tha the Chicago Mercantile Exchange offers Binary Options (of couse I’d have no problem in putting my faith, trust, and money in the CME) and they can be of the very short to the very long-term type which is probably the type of thing you’re looking for.

On the same subject as ‘hedging’ as purplepatchforex noted: it’s something that I have wondered about a lot though. Not for my trading but what’s made me wonder is that even the ‘top ten rated’ fund managers (you know those ‘surveys’ that they have annually) seem to 'come out ‘maximum’ with percentages around the 20% - 30% range. There are retail FOREX traders right here than can probably average that in a one month!!! So my logic tells me that the only reason those ‘top hedge fund managers’ come out with such ‘low’ rates of returns is BECAUSE they’re ‘playing it safe’ (using whatever risk protection option strategies that are available to them at a cost obviously). What do you think of what I’m saying here???

Anyway and AGAIN I digress!!! LOL!!! (I seem to be getting very good at doing that of late)!!! LOL!!!

TO THE POINT Cuddykid: below are some of the links that I was able to find in my ‘favorites’ (most of the ‘good stuff’ I get from Investopedia and I’d advise ANYBODY to register with them to get their ‘daily golden nuggets’ that they send out). (Registration is free anyway and they don’t spam you either although just now and then you’ll get a paid advertisment from one of their sponsors which NORMALLY is not ‘junk’ either). If nothing else: these links explain FX Options and well as FX Futures (and how to use either to minimise risk). Have fun.

Getting Started In Forex Options
How To Use FX Options In Forex Trading
Protect Your Foreign Investments From Currency Risk
Combining Forex Spot And Futures Transactions

As I said though: reducing risk will obviously come at a cost. Same thing as household insurance or a medical plan. You may never use them but you’re going to pay the installments every month!!! LOL!!!

I hope this helps a bit more than my first post.

But as I also noted: if you go this route I think (like anything though) you’re choice of broker is ‘all important’.

Regards,

Dale.

Digressing a little again, but when I hear the term ‘Hedge Funds’ it conjures images for me, not of sensible and good investors using hedging in the same manner as we are discussing in this thread, but of dodgy dealers playing with money of the trusting public hiding behind of the name ‘Hedge Fund’ which in practice at best means a pile of money dealt with by a manager that can do anything he likes with the public’s money.

Then as we see time and time again, when everything is going well, the public make above average returns, the fund managers make a ridiculous amount, then when it goes wrong, i.e. when the glorified ponzi scheme bubble bursts, the fund manager doesn’t get paid that year, but they don’t care since they have millions stashed away from previous years and the poor old trusting public are left carrying the can, and this time round the bubble was so big that your normal decent hard working tax payer that never invested in anything in his/her life is forced to pay out.

Hello,

Once again I have to agree with you (and THIS time with no ‘buts’)!!! LOL!!!

It’s something that’s always angered me, myself, and I, especially when it comes to investment banking. These institutions employ not a few traders but BUILDINGS full of them and what does ‘Joe Public’ get paid out annually??? A mere FRACTION of what they’ve actually made out of YOUR money. I think the very best ‘deal’ you can get here at the moment, from only one particular bank, is a guaranteed 8.5% PER ANNUM on a three-year fixed deposit (which is fixed for obvious reasons i.e. our interest rates are, at the moment, possibly the lowest they’ve ever been, or have been for a very long time at least, so there’s ‘little to no chance’ of another interest rate cut here i.e. it’s only ‘up and away’ from here). And I’d like to say that alright, well, they obviously have huge admin costs but that’s a ‘pile of sht’ too i.e. our bank charges here are some of the highest in the world according to some statistics so you can be sure that the bank charges charged cover most, if not all, of such admin costs, and if their hundreds (BUILDINGS) of traders are only making 8.5% per annum then they should all be fired (actually they WOULD be fired) so as you say: the huge commissions paid to these chaps, plus their profits on trading, well, let’s just say that ‘fair practice’ doesn’t even ‘feature’ into the equation and every year the banks and these investment firms produce ASTRONOMICAL results and even if you’re lucky enough to get paid a dividend now and then it’s nowhere NEAR what THEY’RE keeping for themselves. I think there’s only one sector that 'pises me off’ more and that’s the medical sector (profession). Oh no sorry: ‘bottom of the rung of the ladder’ goes to the legal profession, then real-estate agents, then the medical profession, and then investment banking (in that order)!!! LOL!!!

But as you say: ‘digressing a little again’!!! LOL!!!

Regards,

Dale.

Hey Dale, I saw this post when it was first posted the other day and knew you would answer it thoroughly. I was wondering the same thing as this guy and just wanted to say thanks for answering it so comprehensively.

From the perspective someone who has traded stock, futures and FX options extensively, both individually and in conjunction with the underlying instrument, I can say emphatically: [B]I would not trade a market that didn’t offer options.[/B]

The simple fact is with access to both spot and options (in the same account) you have more trading strategies and more risk management strategies.

The biggest complaint of retail FX traders has to be this: I called (for example) a 6 cent move higher in the EUR/USD – and lost $35,000 for my trouble. Every time I got long I got stopped out, and by the time I re-entered the market was higher – then it whipsawed again I get got stopped out again – and again and again.

On that note, here’s my quick follow up on Cuddykid’s question: Yes, there are lots of risk minimization strategies available using options together with spot. For example:

Get long a spot position and then buy a put option with a strike price where you would otherwise place your stop. To reduce the cost of the put premium, sell a call against your spot position at a strike price above where you would otherwise place your limit order.

(Then relax, let the strategy ride and play some golf.)

If the market moves lower (against) you can:

> Close your spot position at a loss
> Sell your put at a profit (but the profit on the put will not be as great as the loss on the spot).
> Buy back you short call at a profit.

Some hypothetical numbers:

Initiating the strategy:

$0 = Long spot position (no cost to account, margin is not a cost)
-$600 = Buy put option
+$250 = Sell (short) call option

-$350 = Net cost to initiate strategy

Closing the strategy:

-$900 = loss on spot
+$1,100 = from sale of put
-$150 = cost to buy back short call

+50 = Net gain of closing strategy.

Net P/L of overall strategy:

-$900 loss on spot
+$500 profit on put
+100 profit on call

-$300 loss on strategy (as opposed to net loss of $900 on spot alone).

Of course, these are just quick hypothetical numbers, but you can see how this risk minimization strategy can work.

Of course, you could alway choose to just continue to let the strategy ride - because your loss can be no greater than the difference between where you entered your spot and the strike price of your put less the premium of the call option!

Some great posts by numerous people so thank you!
One of the great problems I’m finding is that there is no broker or software that allows you to trade many things (fx, options, futures, commods, equities etc) all ‘under one roof’. The closest I’ve come is saxobank but their hidious reviews and requirement of significant capital is a no no.
As a result the strategy of using options seems to be restricted to only those with enough money to afford the big toys (bloomberg terminal etc).

Hi,

And welcome. And thanks for your post. I see it’s your first. I hope it’s not going to be your last.

Some (trading) friends have been trying for years to get me interested in options trading but I just cannot ‘get my head around them’. Your post, though, does make a lot of (logical) sense. The thing I still don’t understand though is how you ‘balance’ the size of the option to the size of the spot postiion (I hope that makes sense and I don’t even know if that’s possible). In other words: let’s say you long an instrument and price does indeed continue to go up. How do you calculate / ensure that the cost of your ‘insurance’ i.e. you option does not exceed or negate the the profit on the spot position (and visa versa)???

I’m just curious really so if you have the time and interest I’d appreciate your input (I say this only because I’m quite happy with the way that I trade and I’ve learned the very hard was to ‘not fix something that ain’t broke’) but I’d still like to know and, of course, I’m sure your post (this one as well as the one I’m asking for) will be of benefit to others.

Regards,

Dale.

Hello,

Only a pleasure (for my posts anyway).

Well (and not to ‘shoot myself in the foot here’) if I cannot offer it to you then it would be very selfish of me to not point you in the direction that you’re looking for KNOWING FULL WELL that such brokers exist.

Put it this way: Deltastock offers ALL of the above EXCEPT options. That’s why I say I cannot help you with EVERYTHING. However: I do know that ETX Capital (etxcapital.co.uk or etxcapital.com) offer ‘the lot’ and so does IG Markets. Those are two that I know of. (But do yourself a favor and read some broker reviews, particularly on Forex Peace Army i.e. forexpeacearmy.com, before opening an account with ANY broker)!!!

Regards,

Dale.

Hope you can realise that IG MARKETS options cant be excercised. I read this on their website. I have proof.

Please check out or search for HMS MARKETS. Here is their website: HMS MARKETS | Online Trading, Online Broker, Forex, Forex Options, Futures, Stocks ,CFDs, Equities Aha, you have no excuse now!!!

Yehuda Cohn, this post should be stickied and kept at the top of the Newbie page, but unfortunately you did not use the following words, Fractal, Fibonacci, Smart Money, Inter-Bank Market, Fiber, Scalp, 5min, 15 min, 10 min Chart, COT, Divergence, Cable, Pivots, Optimal Trade Entry, Larry Williams. So seeing as you posted one of the most professionally based posts I have ever seen here, your post will soon be lost in the sands of INTERNET time, I don’t even think the word “Yard” could save it now. So from the Ol’ VIPER, a shake of the Eastern Diamond Back rattle for you my friend, well done and well played, and thanks for taking the time. :cool:

The Ever Hedged VIPER