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Comparing Currency Pairs For Profit Potential – Forex options are a relative unknown in the retail currency world. Although some brokers offer this option for spot trading, many do not. Unfortunately, this means investors are missing out.
FX options can be a great way to diversify and protect an investor’s position. Alternatively, they can also be used to speculate on long- or short-term market outlooks rather than trading in the currency spot market.
Comparing Currency Pairs For Profit Potential
Structuring trades in currency options is actually very similar to doing so in stock options. Leaving complex models and math aside, let’s take a look at some basic FX options setups used by both novice and experienced traders.
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Basic option strategies always start with plain vanilla options. This strategy is the easiest and simplest trade, where the trader buys an outright call or put option to express a directional view of the exchange rate.
One of the easiest strategies is to place a direct or bare option position when it comes to FX options.
The AUD/USD chart is showing a double top ideal for a put option. Image by Sabrina Jiang © 2020
Looking at the chart above, we can see the resistance below the key 1.0200 AUD/USD exchange rate in early February 2011. We confirm this with a technical double top formation. This is a good time for a put option. An FX trader looking to short the Australian dollar against the US dollar buys a plain vanilla put option that looks like this:
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The profit potential for this trade is unlimited. But in this case, the trade should be set to exit at 0.9950 – the next major support barrier for a maximum profit of 250 pips.
Apart from trading a plain vanilla option, an FX trader can also create a spread trade. Preferred by traders, spread trades are a little complicated but they are easy to practice.
The first of these spread trades is the put spread, also known as a bull call or bear put. Here, the trader is confident about the direction of the exchange rate, but wants to play it a little safer (with a little less risk).
In the chart below, we see a support level emerging at 81.65 in the early March 2011 USD/JPY exchange rate.
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This is a great opportunity to do a Bull Call Spread as the price level is likely to find some support and move higher. Executing a Bull Call Debit Spread would look something like this:
If the USD/JPY currency exchange rate crosses 82.50, the trade will make a profit of 52 pips (100 pips – 48 pips (net debit) = 52 pips).
Premium through the spread while maintaining a trading direction. This strategy is sometimes called a bull put or bear call spread.
With support at 81.65 and a bullish view of the US dollar against the Japanese yen, a trader can implement a bullish strategy to capture any upside potential in the currency pair. Therefore, the trade will be broken down as follows:
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As anyone can see, it’s a great strategy to execute when a trader is at the top of a bear market. Not only does the trader get the option at a premium, but they also avoid using real money to execute it.
So, what happens if the trader is neutral against the currency, but expects a short-term change in volatility? Similar to comparable stock options plays, currency traders will construct an options straddle strategy. These are excellent trades for an FX portfolio to capture a potential crash or lull break in the exchange rate.
The straddle is a little simpler to set up compared to credit or debit spread trades. In a bear market, the trader knows that a breakout is imminent, but the direction is unclear. In this case, it is best to buy both a call and a put to capture the breakout.
The volatility in USD/JPY in February 2011 creates a perfect bullish opportunity. Image by Sabrina Jiang © 2020
Forex Correlation Pairs & Calculator. How To Trade Using Currency Pairs Correlation
As shown above, the USD/JPY exchange rate fell below 82.00 in February and remained in a 50-pip range for the next few sessions. Will spot rates continue to decline? Or will this consolidation come before the top? Since we don’t know, the best bet is to apply a straddle similar to the one below.
It is very important that the strike price and expiration are the same. If they are different, this can increase the cost of the trade and reduce the probability of a profitable setup.
The potential profit is unlimited – the same as a vanilla option. The difference is that one option expires and the other can be traded for a profit. In our example, the put option expires (-45 pips), our call option increases in value and the spot rate rises below 83.50 – giving us a net 55 pip profit (150 pip profit – 95 pip option premium = 55 pips) .
Forex options are a great tool to trade and invest. An investor can resort to speculative spread trades to capture market direction, not just for hedging or using a plain vanilla call. However you use them, currency options are another versatile tool for forex traders.
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The offerings appearing in this table are compensatory partnerships. This compensation can affect how and where listings appear. Not all offers on the market are included. Spread bets and CFDs are complex instruments and have a high risk of losing money rapidly due to leverage. 71% of retail investor accounts lose money when betting and/or trading CFDs with this provider. You should consider whether you understand how spread bets and CFDs work and whether you can afford to take a high risk of losing your money.
Currency correlations or forex correlations are a statistical measure of the extent to which currency pairs are related in value and move together. If two currency pairs rise at the same time, this represents a positive correlation, and if one appreciates and the other depreciates, this is a negative correlation.
It is important for traders to understand and monitor currency correlations as it can affect their level of risk when trading in the forex market. In this article, we will look at how forex correlation is determined and calculated, how it affects trading and trading systems, and what tools can be used to track currency correlations.
A forex correlation is the relationship between two currency pairs. There is a positive correlation when two pairs move in the same direction, a negative correlation when they move in opposite directions, and no correlation if the pairs move randomly with no detectable relationship. A negative correlation can also be called an inverse correlation.
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It is important for traders to understand currency correlation as it can have a direct impact on forex trading results, often without the trader’s awareness.
For example, assume a trader buys two different currency pairs that are negatively correlated. Often used as a hedging strategy, gains in one can be offset by losses in the other. Meanwhile, buying two correlated pairs can double the risk and profit potential, as both trades will result in losses or profits. Since the pairs move in the same direction, they are not completely independent.
The correlation coefficient represents how strong or weak a correlation is between two forex pairs. Correlation coefficients are expressed in values and range from -100 to 100 or -1 to 1 of the decimals that the coefficient represents.
Anything in the negative range of -100 means the pairs are moving in nearly equal but opposite directions, and anything above 100 means the pairs are moving nearly equally in the same direction. “Approximately equal” is an important distinction since correlation only looks at direction but magnitude. For example, one pair may move up 100 pips (percentage of the point) while another moves down 70 pips. Both pairs can have a very high inverse correlation even though the magnitude of the move is different.
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If a reading is below -70 and above 70, it is considered a strong correlation, as movements in one are largely mirrored in movements in the other. On the other hand, a reading anywhere between -70 and 70 means that the pair is less correlated. Both pairs show little or no detectable relationship with each other, with forex correlation coefficients near the zero sign.
While this formula sounds complicated, the general concept is that it takes data points from two pairs of x and y and then compares the average readings within these pairs. The upper part of the equation is the covariance and the lower part is the standard deviation.
For example, think of data points as closing prices for each day or hour. The closing price of x (and y) is compared to the average closing price of x (and y), so a trader can enter the closing and average values into the formula to extract the pair’s form.
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