Option strategies range from the simple to the highly complex, with the latter requiring a strong understanding of option Greeks to manage them. While the number of strategies is limited only by one’s imagination, we’ll outline only the basic ones here. The choice of an option strategy depends on one’s expectations about two critical factors – market direction and volatility. The strategies to be adopted under different conditions are summarized in the table below.
The table on the last page shows the actual quotes on the ISE for the EUR/USD pair at the close of trading hours on Feb 09, 2010. With the spot closing at 1.3797, the 1.38 options become ATM options. Quotes are given for the first four expiration dates – with call values in blue background and puts in white background. All illustrations will use these quotes.
With the EUR having fallen nearly 10% over 2 months, you think that the sell-off is overdone and it will recover to 1.43 before the expiry of the March contract on 2oth March. Buying a call option would be an excellent strategy for this short-term bullish forecast, especially if volatility is low and expected to remain stable or rise. The selection of the strike price will depend on the expected strength of the move and the desired cash outlay. While a far out of the money position would come very cheap (0.88 cents for the 141 Mar C against 2.09 cents for 138 Mar C) and hence have the maximum potential return on investment (ROI), the risk of loss would be higher if the EUR rally undershoots expectations. A conservative trader would prefer ATM +/- 1 strike – this would reduce the ROI but also lower the risk of loss.
The next table summarizes the outcomes at various settlement values of the EUR/USD on the expiration date i.e. March 20, 2010. It clearly shows that although the 141 call earns higher ROI at the two highest values in the table, the expected return on the ATM 138 call is nearly six times higher and the expected ROI is 2.5 times higher.
Note that the loss is limited to the premium paid if the settlement price is at or below the strike price.
If you think the euro will continue to weaken in the short-term towards 1.33, buying a put option is the appropriate strategy provided you get the forecast right for the underlying price movement, time, and volatility. The ATM 1.38 put costs 2.28 cents while the OTM 1.36 put costs 1.48 cents per euro. Again, the maximum loss is limited to the premium paid while gain would be maximized if the EUR fell to zero.
The table below summarizes the outcome at various settlement prices. The ATM put, like the ATM call, again performs better even with a 5% decline in the EUR’s value.
Selling a call/put is a better way to play a bearish/bullish outlook when volatility, and hence option premium, are high and expected to fall. In such cases, buying a put/call would be costly and the breakeven point (BEP= strike price +/- premium) would be further from the current market price in a trend that would already be stretched. On the other hand, a short call/put position would gain from time decay as well as from a fall in volatility.
The chart below shows that 1 month implied volatility of EURUSD fluctuated between 5% and 29% in 2007-08. As shown in the accompanying table, the premium rises in the same proportion as the volatility. So the premium for a 1-month EURUSD option would have fluctuated between 81 and 470 cents. The high premium is a hurdle to be crossed by the option buyer to make profit while it acts as a protective wall to be breached for the option seller to lose money – it make sense to be a seller when premiums are high and a buyer when premiums are low. Short option strategies are better executed with European style options since American style options carry the risk of early assignment.
A long straddle involves buying a call and put with the same strike and a short straddle involves selling a call and put with the same strike. Straddles are pure volatility plays and are bought when a big move is expected but the direction is not known, which would typically happen after the underlying currency has traded in a narrow range for a long time and/or an important announcement is expected.
An ATM straddle (strike 1.38) for the March expiry would cost 4.37 cents (2.09C + 2.28P), which means EURUSD would have to move beyond the 1.3363-1.4237 range at expiry for a long straddle position to become profitable (see table). A short straddle would earn slightly lower premium than that paid on the long position due to the bid ask spread and the EURUSD would have to close outside the BEP range at expiry for the seller to lose money. Ideally, a long position should be taken when volatility is low and expected to rise and a short position should be taken when volatility is high and expected to fall.
Note that unlike volatility, the impact of time on option premium is not linear. There are 39 days to the March expiry and 130 days to the June expiry – while the time to expiry increases 3.33 times, the option premium is up only 1.92 times.
A strangle is a variation on the straddle and is intended to cut down the initial cash outlay on the premium by buying OTM, instead of ATM, calls and puts.
The table below shows premiums and breakevens for strangles involving the first OTM strikes i.e. 1.39 call and 1.37 put. A comparison of the two tables shows that while the breakeven points increase by less than 10 pips, the cost reduction is substantial (last column). Other considerations remain the same as in the case of a straddle.
Bull and bear spreads are low risk / low return strategies designed to take advantage of modestly bullish or bearish markets and uncertainty about the direction of volatility. Strategies 1 and 4 (long call spread and short put spread) are known as bull spreads since they make money in a slightly bullish market. Both involve buying a lower strike option and selling a higher strike one. Strategies 2 and 3 (short call spread and long put spread) are known as bear spreads since they make money in stable to bearish markets. Bear spreads involve buying a higher strike and selling a lower strike.
The table below shows the performance of bull and bear spreads using 1.38 and 1.41 strikes for the EURUSD across a range of expiry values. Bull spreads apparently have better profit/loss ratios than bear spreads but require reasonable movement in the underlying currency to realize that potential, whereas bear spreads would be profitable even in the absence of movement. 