This section is intended to give you some practical ideas for determining when, and at what prices, to apply an options trade. You can use an option in almost any situation you might otherwise use a spot position, but timing those trades and forecasting price targets are subject to a few unique considerations that you need to keep in mind.

We will look at 3 specific case studies in this lesson. The first is an adaptation of some of the ideas you learned in the Fibonacci course that you can use to modify how you take advantage of a speculative option opportunity in the forex.

The second case study will again use some of the ideas you learned in the Fibonacci course to apply a straddle play. We will be using options with one week left to expiration for that strategy.

Finally, the third case study will revisit the covered options strategy and provide one method for determining what direction you would trade the underlying pair.

Case Study #1: Using Fibs to speculate with options

Following the bounce a trade was triggered at the midpoint between the 38.2% and 23.6% retracement levels. This was a general rule of thumb we talked about for identifying trade entry points in the Fibonacci course. The market price at that mid-point was 100.00 even. Initially we are forecasting that the market will fully retrace to the 0% retracement, which is the bottom of the market established on 3/17 at 96.00.

A short spot position is one way you could take advantage of this situation with a stop above the 38.2% level; however, in this case you will be using a long put option. At the time, a put option with a strike price equal to the current spot price at 100.00 cost the equivalent of 188 pips. That put has 30 days until expiration.

The initial profit target is 400 pips away and your max risk is limited at 188 pips, which is what you paid for the option. But trying to forecast your profits is complicated by the effect of time value on the position.

Time value of the put will melt slowly, the closer you get to expiration and the further the option moves into the money. To make some estimate of what the profit potential is, let’s run three scenarios. In the first scenario we will assume that the market closes at the profit target at expiration. In the second scenario we will assume that the market closes at the profit target in two weeks. In the last scenario we will estimate the potential losses if the market were to move up to where you might have placed a stop loss.

This example illustrates the advantages of using an option for a speculative trade. You have a max loss amount without having to use a stop loss but the position still has unlimited gain potential if the market continues to moved down past the initial profit target.

You can also see how time-value affects the price of your option. Time value can reduce your gains somewhat as the market trends the direction you forecasted but it does not melt as fast when the market moves against you. That helps enhance your risk control. Should you choose to exit the trade once the market reaches the 101.50 level, you have only lost 65 pips rather that 150 through a stop loss.

Case study #2: Using Fibs to find straddles during channeling markets

Often forex traders are stumped when faced with a tightly channeling market or an erratic one. There are a couple of things you can do with options during these periods. One of the strategies that we discussed in this course that can be useful in these kinds of market conditions is short straddles.

In the chart below you can see the GBP/USD, which has had a sustained channel since January of 2008. Recently the market bounced between fib levels with a recent whipsaw from the 50% level to the 23.6% level and is now hovering at the 38.2% level. This back and forth from one fib level to another is a clear sign of a good channel.

Selling options is fairly simple because there are only two things we are concerned about. The first factor is the price range the market needs to stay within, and the second is the amount of time until expiration.

Assume that you are making the decision on 3/25 at the current market price of 2.0070. You feel that without any significant news on the horizon, that a straddle with one week to expiration has a high probability of closing with a profit.

A straddle is constructed in two steps.

First, you will sell a call with a strike price of 2.0070 and an expiration date of 4/2. That call will pay a premium of 100 pips.

Second, you will sell a put with a strike price of 2.0070 and an expiration date of 4/2. That put will pay a premium of 90 pips.

The total premium paid to you as the seller of both of these options is 190 pips. That total premium is then used to establish the range that prices much stay within to make a profit by adding it and subtracting it to the current spot price. You can see those levels drawn on the chart below.

As long as the market stays within that price range until expiration the position will be profitable. At expiration one of these options will have some intrinsic value and one will have none. That is because they share the same strike price. The only way they will both expire worthless is if they close at exactly the same strike price you sold on expiration. That is very unlikely. Let’s look at two of the many possible results to understand how this trade could close.

This is a trade you would consider once the market has given clear indication that it is stuck within a channel. Moving back and forth between fib levels is one great method you can use to identify this trading opportunity.

Case Study #3: Using Fibs to find Covered Options Trades

Selling covered options is a great strategy and is usually used as a way to take advantage of long term moves in the market. One of the advantages of covered options in the long term is that you can be a little looser with your definition of the trend, as long as some kind of trend is defined.

One method that we have found to be very useful when trying to define the trend is to rely on the COT report. COT reports follow the flow of large institutional investments in the forex. You can find a graphic illustration of the COT report on each pair’s dashboard page.

The COT report shows whether institutional traders are net long or short a particular pair. If they are net long it means that the long term trend should be positive. Likewise, if institutional traders are net short that means the long term trend should be down. That analysis is not overly complicated and it gives you a starting point to enter a trade.

Rather than looking at a specific trade I wanted to provide an example of how that works over a recent period on the AUD/USD. For the past few years the COT report has been mostly positive on this pair. However, from October 2007 through the present time, the market has been mostly locked in a channel. That can be frustrating for any long term trader. However, there is a way you can smooth those draw downs while simultaneously providing some upside potential.

The COT report would have indicated that you should be long the AUD/USD during this period. Assume that you sold weekly short calls against this position that were 40 pips out of the money.  That provides some upside if the market did break out but with an average premium of 50 pips that can provide some protection to the downside.

During this period, an outright long position would have returned 159 pips and the covered options strategy returned 416 pips. This is a great return and a good example of the power of covered options during market volatility.

However, I would encourage you to do your own backtesting. You will have to make a few assumptions about options pricing but you now know the strategy and can see for yourself how it would have played in the long term.

Note: In this course, I have illustrated examples by using past options prices and estimating future options prices. Unlike spot prices, option prices have multiple components and can be different over time. There are models you can use to calculate the theoretical value of an option in the past. These tend to be somewhat complex and the value they add to your analysis is nominal.

Typically, you will get a reasonable estimate of an options price or value by looking at current prices. For example, if you know that an at the money call right now is worth 100 pips with 30 days to expiration then you can assume that an at the money call two months ago with 30 days to expiration was worth a very similar amount.

If you want to be more conservative in your analysis or backtesting you may wish to adjust your past prices by 5-10%. That means that you may want to assume that you would have paid 5% more when buying an option or sold an option for 5% less than you might have otherwise predicted. This will give you a good margin for error.

You can also increase your certainty of the analysis by backtesting against more than one pair. The larger your data-set the more statistically relevant your analysis will be.

This is another argument for paper trading. Using live prices in the market will help you get a feel for the variability of option prices over time. You will find that when the market is very volatile, prices tend to be a little higher than normal and conversely, when the market is very quite prices may be lower than normal.

Watch the video below, and move on to Lesson 11: Covered Calls vs. Selling Puts

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3.25 Copyright (C) 2007 Alain Georgette / Copyright (C) 2006 Frantisek Hliva. All rights reserved."