Steve Meizinger. FX Options Strategies for Your Investment Portfolio

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1 Steve Meizinger FX Options Strategies for Your Investment Portfolio

2 For the sake of simplicity, the examples that follow do not take into consideration commissions and other transaction fees, tax considerations, or margin requirements, which are factors that may significantly affect the economic consequences of a given strategy. An investor should review transaction costs, margin requirements and tax considerations with a broker and tax advisor before entering into any options strategy. Options involve risk and are not suitable for everyone. Prior to buying or selling an option, a person must receive a copy of CHARACTERISTICS AND RISKS OF STANDARDIZED OPTIONS. Copies have been provided for you today and may be obtained from your broker, one of the exchanges or The Options Clearing Corporation, without charge, upon request at OPTIONS or Any strategies discussed, including examples using actual securities price data, are strictly for illustrative and educational purposes and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities. 2

3 What moves currency markets? Many traders initially believed it was current account balances Other traders felt it was relative interest rates Ultimately, it is supply and demand that determines a currency value and in the shorter term many factors influence the prices of currencies 3

4 What moves currency markets? If a country's economic outlook improves, there will be a surge of interest and international investors will move money into the economy and thus drive up the value of its currency. Because of this, currency traders pay close attention to indicators that follow the health of an economy 4

5 Nobel laureate in economics in 1976, Milton Friedman The famous economist Milton Friedman once said a central bank can control its exchange rate, it can control its interest rates, and it can control its money supply (inflation). But it can t control all three at the same time. Another simpler view- Risk is not binary, as some investors may believe. There is risk in almost everything, the difficult part is ascertaining an exact quantifiable amount, which of course is almost impossible, but mathematical models try to 5

6 Theoretical view of FX markets Currencies are a means of payment and create a relative price of equal goods in two economies. The exchange rate becomes a factor in global competition A strong increase in a country s currency basically translates into a cost disadvantage in global markets, for which an economy has to make up with efficiency gains 6

7 Currencies are in the news each day Familiar headlines might be: Dollar slumping Dollar rallying Dollar holding steady Today we are kept apprised of the currency market on a more consistent basis 7

8 Yesterday and today in FX Years ago mostly banks and financial institutions traded the foreign exchange market Today retail investors are now participating in this growing market One relatively new development pertaining to the foreign exchange market is the recent introduction of the ISE FX Options offered by the International Securities Exchange 8

9 ISE FX Options ISE FX Options offer diverse opportunities for investors, for both institutional and self-directed Let me compare and contrast what many of you remember as FX trading (trading the cash or spot market) with the ISE FX Options offering The comparisons should help illustrate the benefits of ISE FX Options in view of your specific financial goals and risk tolerances 9

10 ISE FX Options, are they right for you? The best way to decide if a certain asset class or investment tool is compatible for you is to fully understand what the instrument is and what it is not Here are some commonly asked questions: What are options? How can I learn all the terms that are necessary to trade them? Here are just a few of the terms: Rights, obligations, premiums, strike prices, intrinsic value, expiration, calls and puts, settlement etc Options give investors many more choices than the cash market increasing your investment choices 10

11 What are options? Have you ever been given a coupon to purchase a product at reduced price? That is similar to owning a call option. Have you ever bought insurance on your car or house? That is a form of a put option. The most basic premise of options are related to rights and obligations There are two basic types of options: Calls- The right to buy Puts- The right to sell 11

12 Fundamentals of options Owners of options have rights, sellers receive obligations Buyers of options pay premiums to the sellers in return for the rights Buyers can control an asset at the strike price for a certain period of time There are many choices for the time period chosen. Investors can select from various expiration months 12

13 Options allow for choices ISE FX Options are US dollar relative Calls can be used to implement a bullish USD dollar view Puts can be used to implement a bearish USD dollar view 13

14 Options on the exchange rate itself ISE FX Options are USD based I will explain more about the trading convention 14

15 Initial ISE FX Offerings ISE SYMBOL ISE VALUE FX value *100 USD/EUR (ticker symbol, EUI): ( x 100) USD/GBP (ticker symbol, BPX): ( x 100) USD/JPY (ticker symbol, YUK) ( x 1) the rate modifier is 1 for JPY USD/CAD (ticker symbol, CDD) ( x 100) USD/AUD (ticker symbol, AUX) ( x 100) USD/CHF (ticker symbol, SFC) ( x 100) 15

16 Contract notional value Due to the options based on the exchange rate itself the contract does not carry any fixed notional value. But, you can easily calculate what the value is worth by multiplying the ISE value *

17 Advantages and disadvantages of ISE FX Options Pros Options allow for limited risk when you purchase options Liquidity is growing Can hedge currency risk in the spot market Various options strategies are available Cons Time premiums depreciate through time Market is only open during equity market hours Only the majors are available for trading USD relative to CAD, EUR, GBP, JPY, AUD and CHF 17

18 Option Greeks also apply in FX options Delta Gamma Theta Vega Rho 18

19 Options are available on many asset classes Options give investors many alternatives ETF s Equities Currencies Regulated by S.E.C. in Washington D.C. One major difference between ISE FX Options and the cash FX market is that your account is not held by the exchange Equity brokers hold the accounts eliminating any potential conflicts on interest that exist in the spot market 19

20 ISE FX Options trading convention According to the Bank of International Settlements in December 2007, approximately 86% of all foreign currency transactions involve the US dollar Since the USD is the predominant currency ISE felt that it was just natural to make the ISE FX Options US dollar based 20

21 ISE FX pairs (prices as of ) EUI U.S. dollar/euro *100 BPX U.S. dollar/british pound *100 YUK U.S. dollar/japanese yen *1 CDD U.S. dollar/canadian dollar *100 SFC U.S. dollar/swiss franc *100 AUX U.S. dollar/australian dollar *100 21

22 What is the US dollar worth? Since ISE FX Options are US dollar relative, if you are bullish on USD you could buy calls If you are bearish on USD you could buy puts The use of the dollar relationship creates a standard trading convention 22

23 Features Of ISE FX Options Options on exchange rates U.S. dollar based.50 strike prices Premium quoted in U.S. dollars European Exercise Cash-settled Noon Settlement/Option Friday Noon Buying Rate FRB of NY Available in Conventional Brokerage Account Continuous Two-Sided Quotes Trading Hours 9:30 4:15 23

24 Some popular institutional strategies for FX Carry- Trying to profit from the expected future value (the forward price of today) and the expected forward sometime in the future Trend- Watching certain technical support and resistance points Value- Possibly based on theories such as PPP or quite simply the Big Mac index Volatility- Forecasting certain potential price ranges and balancing those ranges with the implied volatilities in the marketplace 24

25 Why are currencies gaining in popularity? Lower interest rates make currencies an attractive asset class for diversification because currency investments tend to have low correlation with equities and bonds Currencies tend to have lower correlation to other systemic risks inherent in the equities market 25

26 Traditional currency roles Hedging currency risk, especially lower yielding bond investments Trading currencies to enhance returns of a portfolio, larger institutions began to consider not only the hedging opportunities but occasionally the directional opportunities Currently some experts believe that the currency market is an alternative asset class 26

27 Governments.. And markets Market information tends to viewed in different ways creating opportunities for market participants Political pressure from various entities can sometimes encourage Central Banks to act in ways that are not consistent with market forces 27

28 SPY in US dollars 28

29 USD/CAD ISE symbol CDD 29

30 USD/JPY ISE symbol YUK 30

31 USD/AUD ISE symbol AUX 31

32 USD/EUR ISE symbol EUI 32

33 USD/GBP ISE symbol BPX 33

34 USD/CHF ISE symbol SFC 34

35 Many assets to own Equities Bonds Foreign currencies Commodities Real estate 35

36 Financial plan Which asset is right for you? Your age, your financial needs and your ability to take risk all influence that decision among other factors What is risk? The potential to lose some or all of your principal investment 36

37 Markets are about probabilities The only certainty in the markets is uncertainty Words such as impossible and guarantee should probably be replaced by highly unlikely and most likely Investors must decide if the risk is worth the reward Understanding financial risk can help investors decide which assets are right for them Many investors may want to consider diversification, finding assets that have relative value but do not move like other assets they may already own 37

38 Options Options allow investors to target their own short to intermediate term goals Versatile tools that allow investors to make their own risk/reward choices Investors can choose from a variety of objectives: Hedge investments Implement price forecasts with limited risk Increase portfolio returns by selling options Create unique payoffs by using spread strategies 38

39 What is best options strategy? Investors can trade equity, index, ETF and foreign currency options, which options strategy is best? There is no one best strategy, each strategy will have periods that either outperform or under-perform depending on the strategy selected and the concurrent market environment 39

40 Managing positions Financial success may depend just as much on managing both your winning and losing positions If your portfolio has many positions that all are expected to move in the same direction at the same time, that is good if you know that the market is moving in your forecasted direction, but what if you are wrong? This is the real message of diversification, to minimize the probability of catastrophic losses 40

41 Diversification, why? 2008 has been a challenging year for the overall market and specifically the financial sector which has experienced significant losses Individual equities can and do move much further up or down than ETF s, some examples Worldcom, Enron 2008 financial stocks Internet stocks Individual stocks, even some sectors may not revert back to their previous price ranges Individual equities tend to have much higher volatilities than ETF s Groups of stocks tend to balance themselves out as opposed to individual stocks- This is what is known as the concept of correlation 41

42 Correlation, what is it? With the goal of diversification in mind, correlation helps investors to understand how different asset classes and specific assets might react to changing market conditions Without an extensive amount of mathematics, one definition is the strength of a linear relationship between two variables An even more practical view, how one asset moves in relation to another For correlation to exist, the relationship must be somewhat linear, or one variable must have some effect on the other 42

43 Correlation A perfect correlation would be 1.00 and perfect inverse correlation relationship would be The efficient market portfolio theory states that rational investors should seek to buy undervalued assets with low correlations to your existing assets An example with a high inverse correlation is commodities to bonds. Normally bonds do poorly during periods of inflation but commodities do well 43

44 Foreign currency Foreign currencies have traditionally shown low correlations to equities and bonds Considering the versatility that the listed options market provides, investors may want to consider some of their favorite options strategies in the ISE FX Options market to reduce their correlation risk 44

45 Correlation Assuming you have a favorite options strategy and that all options strategies work, they just do not work all the time Most equities and ETF s are lower in price in 2008 Equity volatility is generally much higher FX volatility has been increasing also, but FX volatility tends to be less than equity volatility 45

46 ISE FX Options 12/31/07 9/17/08 Change SPY % YUK % EUI % CDD % BPX % AUX % SFC % 46

47 ISE FX implied volatilities High Low Last YUK CDD EUI BPX AUX SFC

48 FX an asset class? Prior to the globalization many investors kept their money in their local equity and bond markets for safety reasons The new modern portfolio theory states that rational investors should seek undervalued assets with low correlations that will help smooth out investment results 48

49 The portfolio approach An investor might want to add low correlated instruments to their portfolio to smooth out the results An investor might be want to choose some of their familiar equity option strategies in the FX market since the correlation to the equity market is somewhat low 49

50 Why trading non-correlated assets might make sense Whether you like to trade with a directional bias or trade with more of a volatility bias, FX options may possibly smooth out your trading results Portfolios need to be actively managed Managing assets that aren t all moving in the same direction is much easier 50

51 Positive correlation As X increases Y increases 51

52 Negative correlation 52

53 No correlation 53

54 High correlation A real world example 54

55 Equity volatility relative to stock index volatility Equity volatility tends to be higher than currency volatility 55

56 Rolling 5 year correlation of equity and currency returns 56

57 CDD examples, trade date 9-16 December CDD options, CDD priced at Call price Call delta Put price Put delta

58 Bullish on USD/CAD CDD You can buy a call to limit your risk There are many months to choose from, for illustrative purposes, I have used December prices in my examples. FX options are available through a ten month duration Call price Call delta

59 Bearish on CDD You can buy a put to limit your risk Put price Put delta

60 How about call spreads? Bullish on the USD but want to reduce your time decay and volatility risk How about buying one call option and selling another? Call spread Price 101/ / Delta of spread 107/ / /

61 How about put spreads? Bearish on the USD but want to reduce your time decay and volatility risk How about buying a put option and selling another put option Spread Price Delta of spread 101/ / / / /

62 How about buying uncertainty Looking for a big move in the exchange rate but uncertain which way? Straddles Strangles Call price Call delta Put price Put delta

63 Risk reversals In foreign-exchange trading, a risk reversal is the difference in volatility (delta) between similar call and put options, which conveys market information used to make trading decisions 63

64 Risk reversals Call price Call delta Put price Put delta

65 CDD example Since the out-of-the-money call(s) have a higher delta relative to the puts, the market information conveyed gives the USD a slight upward bias in relation to CAD This risk reversal conveys the emotion of the market Please remember, theoretically the options market generally has a 50% chance of moving up or down on any specific day, week or month 65

66 Summary Options allow investors many choices for their portfolios Investors use options for: Limited risk when implementing specific forecasts Hedging particular asset risk Unique tradeoffs can be created using a myriad of options strategies to meet your specific goals in view of your particular risk tolerances 66

67 Summary Currency trading has become much more popular in recent years ISE FX Options can be traded directly through your IB account Options are based upon probabilities, investors must keep in mind risk and reward when entering any options transaction FX options may create allow investors to diversify their portfolios. Please remember though, correlations can change Never trade beyond your risk tolerances, please consider the implications of all your positions prior to entering into the positions 67

68 ISE FX Options education Industry experts join ISE each Tuesday on the ISE weekly webinar series Future Sunday evening webinars are also planned

69 Steve Meizinger

Weekly Options Secrets Revealed: A Proven Options Trading Plan

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