Selling options, and specifically selling covered options, are the most powerful hedging strategies available to FX options traders. Therefore, it is the strategy we are spending the most time on within the options essentials course.

You’ll remember from the last section, these options are used to hedge against risk in a long spot position. In this section we will discuss how and when you might adjust your option position before expiration to further minimize risk, while keeping your spot trade open to profitable moves. Adjustments are important, and help increase the effectiveness of the hedge.

Adjustments to a covered option are desirable when the market is trending against your spot position. So, if prices are moving the direction your analysis indicated, there are no changes necessary.

However, if the market is trending against your spot position, the short option you sold will be losing value, which is good because you sold the option for a higher price and can now buy it back for a profit. Then, you can sell another option closer to the current market price and start the process again. Let’s look at a specific example.

In the chart below, the NZD/USD had a positive overall trend. Assume that you held a long spot position on the pair at .8170 on 2/26/2008. Unfortunately, that means that you were holding a long position on the NZD/USD at the very top of a rally. Let’s also assume you had sold a call against this long position.

On 2/26/2008 the spot price was .8170, so let’s assume you sold a call at .8200 with one month expiration for 100 pips. By 03/06/2008 the market had declined significantly to .7970 against your spot position, so at this point you would pause to evaluate the status of the trade.

The long position has a loss of 200 pips. If the long position was entered at .8170 and is currently priced at .7970 it has lost 200 pips.

The call option, however, has gained 57 pips. You originally sold the call for 100 pips, but it fell in value as the market declined. On 03/06, it was worth 43 pips, so you could have bought it back for a 57 pip profit.

By early March, the total position (the spot trade and the short call) had declined in value by 143 pips (200 pips – 57 pips.) You may still have felt confident overall that the pair would rise as your analysis projected, so you could hold the spot position and simply re-adjust the option position to provide a new hedge. You do that by buying back the old option as explained in the previous paragraph, then, you follow these steps to sell a new option hedge position.  

Step 1 – Open a second short call position:

Because you are adjusting this position, you would sell a call with the same expiration date as the first option you just bought back. You should sell the call so that it is 30-50 pips out of the money to allow for some additional upside. If you had done so in this trade, you would have collected another 95 pips in option premium for a call with a strike price of .8000 even.

If we freeze the position on March 24, and assume the market closes at .7984 at expiration, we can calculate the final P/L for the position with options, versus the outright spot position alone.

Compared to the potential losses on the outright spot position, this was a very effective hedge.

Here are some important tips for selling and adjusting covered options against spot positions.

1. Reselling another option is usually a good idea once the original call has lost half its value. You can see that was the rule applied in the example above. 

2. If the market breaks out very close to the original expiration date, the premiums available for another call with the same expiration date may be too low. In this case, we usually just recommend just closing the older call and selling another one 30 days in advance, as though you were entering the position for the first time.

3. If you are interested in active management, one of the best things you can do is to shorten the original expiration time frame. Specifically, this means you may be selling options with one week before expiration 4 or 5 times per month rather than one option every 30 days.

This means that you will be “adjusting” the position every week as each option expires and it usually creates a larger total premium.  In the video I will look at a specific example of this idea.

4. DIVERSIFY!!!! I know we keep harping on this,  but options are an especially great strategy to use against a pool of currency positions. That way, you are spreading your risk more efficiently across a larger pool of currencies. Diversification smoothes your equity curve and makes your use of capital more efficient.

5. Paper trade this strategy to get some real life experience. Understanding how something works in theory is good but nothing will help you understand it better than paper-trading. The practice will allow you to see how prices change with time and give you a better feel for whether this is a strategy you could deploy in your own portfolio.

Watch the video below, then proceed to the next lesson: Options Technical Trading Applications

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chinny  - Thank you!   |2009-07-23 19:44:01 I have learnt so much about FX options from this website and watching the videos - Thank you sooo much! you are a great teacher!

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