Straddles and Strangles

Straddles and Strangles on Volatile News Events

Situation: You see a volatile news event coming and you don’t know which way the pairs will go so you buy a straddle to profit from movement in either direction.

Action: Buy 1 put and 1 call on the GBP/USD at the money (at the strike price) for an estimated cost of $1100 one day prior to the volatile news event ($550 each).

After the news:

One Possibility - The GBP/USD moves up or down by at least 55 pips to break even, anything past there would be net profit, when most or all of the movement is over close out the straddle.

In the image above the straddle would remain unprofitable if the GBP/USD did not move and remained in the yellow area, if the pair moved either way significantly and into the blue area the straddle becomes profitable.

Another Possibility - The GBP/USD goes sideways but does not move enough to produce a net profit, wait until expiration after the puts and calls expire and create a covered put or call from the position assigned. This will repair or minimize the loss that should have occurred.

Strangle – Buying equal amount of puts and calls at out of the money prices.

Everything is the same as the EUR/USD example above however you would use strike prices out of the money, so then your premiums would decrease.

Benefits of Straddles - Unlimited Upside

Straddle certain news announcements that are historically volatile and put on the trade about 48 hours in advance at the money and make it expire the day of the announcement and closes out roughly 2 hours after the event regardless of the outcome.

Below is the compiled volatility statistics based on the last 5 years:

1. Non Farm Payrolls – Unemployment Average Move: 125 Pips

2. FOMC Interest Rate Decisions Average Move: 73 Pips

3. Trade Balance Average Move: 62 Pips

Put and Call Protection

Situation: You see a volatile news event coming and you own a buy position that is strongly profitable and want to protect the profits ahead of the news.

Action: Buy 1 put option with custom expiration good for one or two days on the buy position.

After the news if the spot position drops in value you are protected by the put, if the spot position goes up you lose the value of the put but the spot position increases in price. This is like an insurance policy on your profits. You can do the exact opposite with a sell position and a protective call option.

Demo Accounts and Demo Trading

In the webinar lesson related to currency options we suggest several currency options brokers and provide you with a list of brokerage options. You can open an options demo account with any of them and paper trade. Paper trade strategy #1-4 and you may be able to use options as part of your forex trading arsenal.

Selling a Currency Pair Versus Option Trade

If you are ready to sell a currency pair (spot trade), you have two other choices, you can either buy a put option or sell a call option and you are essentially accomplishing the same thing but you will not own a spot position at all. If you sell a call you will receive a cash premium in your account immediately and if the pair keeps dropping you will keep the cash premium in your account at expiration. To exit the trade, wait until expiration and the option expires worthless. You can also set a limit order to close out your call position for when it reaches a certain value. You can also set price alarms to notify you of any price movement back towards the strike price:

Example: The GBP/USD is trading at 1.4800 and you would like to sell it, instead you sell 1 call option at a strike price of 1.4800 good for one week, you will receive a cash premium in your account estimated at $_____. If the pair stays below 1.4800 for one week you keep the premium. Remember that for this example you never buy or sell a spot position at all you are using an option instead.

Buying a Currency Pair Versus Option Trade

If you are ready to buy a currency pair (spot trade), you have two other choices, you can buy a call option or sell a put option and you are essentially accomplishing the same thing but you will not own a spot position at all. If you buy a call you will pay cash premium out of your account immediately and if the pair keeps rising the value of the call will appreciate. To exit the trade, wait until the pair stalls at resistance and cash out the call by selling it (close to sell). You can also set a limit order to close out your call position at a predetermined profit. If you buy an even number of calls you can close out half of your calls by selling them. You can also set price alarms to notify you of any price movement back down towards the strike price. The advantage here is good in that the cost of the call option is less than the spot position.

Example: GBP/USD is trading at 1.4800 and you would like to buy it, instead you buy 1 call option at a strike price of 1.4800, which is at the money, good for one week, you will pay a cash premium out of your account estimated at $_____. The GBP/USD rises and your option is now worth $________. You sell the option to close the position and keep the difference. If you pay a $600 premium, when the price increases to 1.4860 you will have a double before commissions, the option will be worth $1200. Not bad at all !!

Judging The Possible Outcome of Options Trades - When judging their possible outcome of an options trade, just enter the paper trade and track the underlying spot position. Did the pair go up, down, or sideways after you entered? Record the results in your journal book up to expiration.

For example if you sell a covered call and the pair moves a lot higher you cannot lose money on this trade but will not participate in any further profit on the spot position. So no risk here. However if you sell a straddle and the pairs moves beyond the strike price of the puts or calls that you sold your account is now at risk, you must monitor this type of trade with price alarms or entry orders to manage the risk in case of the unexpected movement, so the risk scenario here is much higher than the covered call scenario in the paragraph above which has almost no risk.

Learning Resources - If you have reached the point in your forex trading where you are ready for options, you are a likely a more advanced spot forex trader. You can go to the suggested currency options broker web sites and most of them have strategy discussions along with glossaries. A little bit of study and paper-trading and you will start to see the value of options along with the ForexEarlyWarning trading plans, knowledge of the trend, and the Forex Heatmap®.

Exercise and Assignment - All puts and calls that are in the money are exercised the day of expiration at the specified time with a spot position, there is no premature assignment. Out of the money options expire worthless.

Summary and Conclusions - With currency options at our disposal we can now trade the spot forex when it is trending and occasionally trade puts or calls when the situation warrants it. As trend traders we know sometimes the market goes sideways with no trend and now we have more weapons in our arsenal to profit from sideways movements in the market and strategies to protect our positions. Set up a demo account to test or demo trade any of the options strategies presented here before starting with real money.