The good news is that there is a variety of other strategies out there that are not a simple black or white bet on the market going up or down at a point in time.
Most of these alternatives involve options of one form or another. I’ll explain more below.
The Dilemma of Long/Short Trading Odds
Let’s take a basic example. When you open a position in EUR/CAD, for example, you have a 50% probability of profit. The market can only go one of two ways. Either up or down.
Technical and fundamental analysis might create a small edge in this example. But at the end of the day, taking long or short positions is statistically equivalent to a coin toss. And that’s indisputable.
This is not to say, however, that there is anything wrong with this style of trading, because enormous fortunes have been made by simply going long or short and getting out at the right times.
But sometimes traders take positions at the wrong time, or they miss opportunities that offer better risk/reward than simply trading a currency pair.
One solution to this is using options on currency futures to create a so called directional spread trade. This kind of spread trade, which is not to be confused with calendar spreads, offers a solution to the aforementioned staleness of 50/50 currency trading.
Futures Options as a Solution
As you probably know, there are no official exchanges that allow you to trade spot foreign exchange contracts. However there is a wide range of currency options and futures that do trade on exchanges. And exchange traded instruments offer the advantage of transparency and fund security that over-the-counter spot trading does not.
Therefore one popular way to establish directional positions in a currency pair is with currency future options.
For example, let’s suppose you are bearish on the euro.
There are a few ways you could express this view in the market. By far the most common way is to sell a currency pair with the euro, like EUR/CAD.
The maximum profit for this trade is EUR going to zero. The maximum loss is theoretically unlimited because in theory EUR could rise to any level and CAD could fall to zero. Of course both cases are highly implausible because unlike stocks for example, currencies are underwritten by sovereign states or supranationals (as with the euro).
So how could you circumvent these somewhat crummy odds of profitability and undefined losses?
One way is to simply sell a call or put credit spread using euro FX futures options. Although that may sound like a lot to take in, it’s very straightforward once the basics are understood and not too much harder than spot trading. Let’s take an example.
If you need a refresher on options trading, you might want to have a quick read of my beginners’ options tutorials first.
Example: CME Euro FX futures
EUR/USD futures and options on these contracts trade on the CME.
This market is highly liquid with plenty of daily volume and trading costs are relatively low.
For example, let’s take EUR/USD futures. These are just listed as euro FX futures on the CME because everything is assumed relative to the US dollar.
Let’s say euro FX futures are trading at 1.12545. A call credit spread would be a bearish view on EUR/USD. The spread trade would look something like this:
Sell 1 x call on euro FX futures @ strike 1.1400 with 30 days to expiration
Buy 1 x call on euro FX futures @ strike 1.1550 with 30 days to expiration
Note: Both calls need to be within the same options series. i.e., same expiration period.
USD +537.16 credit from sale of call
USD -239.00 debit from purchase of call
Net: USD 298.16 credit
The behavior of this system is quite similar to that of the other spread trades.
The table below shows the various payoffs for different levels of EUR/USD futures at time of expiration.
|EURUSD Futures||Short call||Long call||Total||Net Gain/Loss|
You can easily adjust the strike levels to get different risk/reward payouts. For example you could move the strikes closer to the spot to gain a higher profit versus loss. This would though come at the price of having a narrower buffer before the upward movement of EUR/USD tips the system into loss.
What’s good about this system is that you know in advance exactly what your maximum potential profit and your maximum potential loss will be.
The system can be created on the put side as the mirror image. This would create a bullish assumption. The ideal scenario for a call or put credit spread is that both legs of the spread expire entirely worthless out of the money or decrease in price substantially.
The beauty of credit spread trades is that you receive the money upfront as soon as the trade is made. Hence the name “credit” spread. In the cash and sweep vehicle of the trader’s account, you will notice an increase from whatever premium is collected by making the credit spread. Unlike a “coin flip” bet on FX spot prices, this payout is a certainty.
Moreover, you have the autonomy to pick any strike prices you want for different deltas.
For example you could sell a 40 delta option and a 20 delta option to from a credit spread. Or you could sell a 5 delta option and a 1 delta option; it’s entirely up to you.
Along these lines, lower delta options have a much greater chance of expiring out of the money. So the probability of profiting on a low delta credit spread trade is quite high.
Why FX Credit Spreads Work
Of course there are no certain bets in financial markets. However there are several key elements working in your favor when this trade is put on.
First, theta decay is collected every day while you, the trader, do absolutely nothing. As a seller of the option, this income is trickling into your account night and day.
This is a key element to an option’s price, time value. Theta is systematically priced out every day and favors you, the seller of credit spread.
Second, you can be profitable with this trade if the euro rises slightly, stays the same, or falls dramatically. No spot trade can ever give you that kind of payout certainty.
In the above example, even if the euro trades up to 1.1400 at expiration, the trade will still be fully profitable since both legs of the spread are not in the money. This aspect of currency credit spread trading is highly alluring.
As with anything in trading, it is not entirely without risk. Of course out-of-the money credit spreads do not work every time. Moreover if both options end up being in-the-money at expiration, the trade will be at full loss.
What that means is you will have to either pay to buy the spread back at the defined maximum loss. Alternatively you will have both of the spread legs exercised. The difference between the two strike prices will be automatically debited from your account. Your net loss (including the credit from the option sale) would be –USD1201.84 in the example I gave above.
If the latter happens, the position will be removed from your account and you will be charged a futures options exercise fee, which can be costly. Therefore, it’s always best to buy back an in-the-money spread before the given futures product stops trading on expiration day.
Difference between Synthetic and Organic Short
The difference between being synthetically short the euro via a call credit spread and being organically short the euro via a currency pair is this:
Assuming a credit spread has reached its maximum loss at expiration, there is no time left for the trader to be right and for the position to turn profitable.
By shorting the euro outright, you could hold this position indefinitely if funds allow. Even if it is going against you – as long as your margin requirements are met.
Perhaps the hidden risk to credit spreads is the time aspect. This is because you could sell a call credit spread in the euro with eight days to expiration. The euro could then rise for the next eight days straight and then precipitously decline on day nine.
If you were short the euro via the spot market, you could still have a profitable position. On the other hand the spread trader would be entirely out of luck with a guaranteed losing trade.
This is a double-edged sword. If you think a currency will decline for the next few days, or even the next few hours, you could establish a high-gamma credit spread position with only a few days or a few hours until expiration. As with the strike price selection, the time to expiration is completely up to you the trader.
Different combinations suit different trading styles. It is important to note, however, that theta starts to be precipitously priced out of options at around 50 days to expiration; anything over this, as a general rule of thumb, theta decay is not as noticeable. This relationship of course depends on the underlying volatility which is a changing variable. This is where knowing “the Greeks” comes in useful (see our Excel option pricer below).
Remember as a seller of an option you are effectively “going short volatility”. The exact amount of credit you receive will depend on the prevailing volatility in EUR/USD. And while you benefit from selling the option at a higher price, remember you also have to buy the option on other side of the spread which will also be priced higher.
With all of this said, the aim of this article is merely to shine light on an alternative way to express a bullish or bearish view on currencies, namely selling credit spreads.
Of course, the markets are too efficient to leave free money on the table. So credit spreads are not a panacea to becoming a lucrative trader. Rather they are just another tool to have when deploying strategies on the markets.