How to Use Options To Trade Forex
Accessing the right tools to execute more complex or uncommon trading strategies is certainly a challenge, but something that can be overcome with time and research. This article will build on the foundation laid in an earlier article “How to Short Forex with an ETF.” The first article provided more of a primer on the subject, this article will explain what calls and puts are and how the price of an underlying stock affects its option price. I will also provide a non-exhaustive list of stocks that can be used to trade forex over longer durations, sometimes as far out as two years.
The objective is to show the reader why this is a good alternative strategy to trading forex directly. The stocks I highlight are accompanied by two charts which will show the closeness of relationship between the performance of a given stock and its underlying currency. The stocks chosen for this article show high positive correlation with their underlying currencies.
What are Call and Put Options?
Options are contracts that give the bearer the right, but not the obligation, to either buy or sell an amount of some underlying asset at a pre-determined price at or before the contract expires…Options belong to the larger group of securities known as derivatives. A derivative's price is dependent on or derived from the price of something else. Options are derivatives of financial securities—their value depends on the price of some other asset. Examples of derivatives include calls, puts, futures, forwards, swaps, and mortgage-backed securities, among others.
Let’s clarify the definitions above using Apple (AAPL) as an example. If one were to purchase an Apple (AAPL) call or put option, the price of the option itself would be dependent on the value of the underlying Apple (AAPL) share. The mechanics of how one makes money if the call or put option is held to maturity is best saved for another post due to its complexity, however, there are two important ideas to keep in mind for now. First, if you think the price of Apple (AAPL) is going to increase in the future, then you want to purchase a call option, the right to buy a stock at a specified price in the future. Second, if you think the price of Apple (AAPL) is going to decrease in the future, then you want to purchase a put option, a right to sell a stock at a specified price in the future.
Be careful though. Options lose their value as they get closer to their expiration dates. If you plan to trade an option that expires in four months then you should plan to sell the option long before the expiration date. An example of a call and put option are provided next. Shares of Apple (AAPL) last traded for $119.25 and will be used for our illustration.
Let’s say you think the price of Apple (AAPL) stock is going to increase significantly over the next couple months, so, you purchase a $120.00 call option which expires on January 15th, at a cost of $6.00. The prices in the example come directly from Robinhood. I chose this option because it was based off of a $120.00 share price and thus closest to the current price. If the price of Apple (AAPL) stock increases, so will the value of your option; conversely, if the price of Apple (AAPL) decreases the value of your call option decreases.
Let’s say you think the price of Apple (AAPL) stock is going to decrease significantly over the next couple months, so, you purchase a $120.00 put option which expires on January 15th, at a cost of $6.60 (again, figures taken directly from Robinhood). A put works in the opposite direction of a call. If the price of Apple (AAPL) stock decreases then the value of your option will increase; conversely, if the price of Apple (AAPL) increases then the value of your call option will decrease.
One last point of emphasis needs mentioning before we move on to the next section. Call and put options are sold in bundles of 100 contracts. If you purchased the Apple (AAPL) put option provided in the example above then you will need to spend $660.00 ($6.60 x 100 contracts). Also, it's important to note the price of option is based on values well above and well below the actual price of the underlying stock, however, that introduces additional complications that I would prefer to leave out for right now. Lastly, just to reiterate, my strategy does not involve holding calls or puts until maturity so a description of that process has been purposely left out.
Relationship Between ETFs And Their Underlying Currency
It is at this point of the discussion that I want to introduce the stocks I watch. As you will see in the series of charts below, some stocks are a better fit than others, however, as a general rule, the stocks I provide do a good job of tracking the relative strength or weakness of the underlying currency. Both the underlying currencies and the stocks themselves are denominated in US dollars, the world reserve currency.
Brazilian Real and EWZ
Chilean Peso and ECH
Chinese Yuan and MCHI
Colombian Bolivar and GXG
Indian Rupee and INDA
Korean Won and EWY
Mexican Peso and EWW
South African Rand and EZA
Turkish Lira and TUR
Again, when making observations between an underlying currency and its corresponding stock, it is important to note that some relationships are a better fit than others. Furthermore, a relationship may hold at some points on the timeline but break at others, so, it is important to follow geopolitical and macro events.
Why Understanding Currency and Exchange Rates Is Important
Currencies float in value against one another in the same way as goods and services. The objective is to always buy low and sell high, which is easier said than done. Currencies fluctuate in value against once another frequently due to competitive debasement. If one can successfully navigate the ebbs and flows of exchange rates then there is a good chance that this process of debasement will have less effect.
As a note for readers living outside of the United States, these stocks are unfortunately only listed on the New York Stock Exchange (NYSE) and thus require permission to operate in US markets. My hope is that the information in this post makes it easier for the reader to experiment with more complex and nuanced trading strategies. Best of luck to you.
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