TECHNICAL ANALYSIS IN FX OPTIONS FOR DIRECTIONAL FX TRADING

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1 TECHNICAL ANALYSIS IN FX OPTIONS FOR DIRECTIONAL FX TRADING Tim McCullough July 2014

2 Contents Summary of trading single FX options versus FX spot and forwards Summary of trading FX risk reversals as proxy for FX forwards (for hedging or speculation) Implied volatility as pricing benchmark for FX options and risk reversals Comparison of non-rational, trending nature of risk-reversals versus spot Use of technical analysis in risk reversals for additional trading signals in underlying spot 2

3 Trading FX via FX forwards versus FX options GBP/USD example Spot: month forward: (spot month forward points ) Buy 3 month GBP/USD FX forward: contract to buy GBP / sell USD at months from now No flexibility but no premium payable Buy 3 month GBP/USD GBP call option Right to buy GBP at in 3 months time, but can walk away if GBP/USD < at expiry Pay upfront premium, equivalent to GBP/USD Profitable if GBP/USD > at expiry ( premium paid) Sell 3 month GBP/USD GBP put option Obliged to buy GBP at in 3 months time, if GBP/USD < at expiry Receive upfront premium, equivalent to GBP/USD Profitable if GBP/USD > at expiry ( premium received) 3

4 Payoff Profiles: FX forward versus FX call & put options GBP/USD P & L GBP/USD at expiry GBP/USD 0.15P & L GBP/USD forward Unlimited P & L around forward level Buy GBP call option Unlimited profit > breakeven level Limited loss = GBP/USD premium paid GBP/USD at expiry GBP/USD 0.05 P & L Sell GBP put option Limited profit = GBP/USD premium received Unlimited loss < breakeven level GBP/USD at expiry 4

5 Trading FX risk reversals as proxy for FX forwards GBP/USD example Spot: month forward: (spot month forward points ) Buy 3 month GBP/USD GBP call option (25 delta) Right to buy GBP at in 3 months time, but can walk away if GBP/USD < at expiry Pay upfront premium, equivalent to GBP/USD and simultaneously Sell 3 month GBP/USD GBP put option (25 delta) Obliged to buy GBP at in 3 months time, if GBP/USD < at expiry Receive upfront premium, equivalent to GBP/USD Net premium = zero (as in FX forward) 5

6 Trading FX risk reversals as proxy for FX forwards GBP/USD P & L GBP/USD at expiry Unlimited profit if GBP/USD > at expiry Unlimited loss if GBP/USD < at expiry Zero profit or loss if GBP/USD between at expiry 6

7 Implied volatility FX options mainly traded on over-the-counter basis Fully customized, unlike exchange-traded options How to assess relative value of similar options with varying parameters? Benchmark feature of option pricing is implied volatility Quoted as anticipated % volatility, on annualized basis Options traders price and quote vanilla options (ie non-exotic) in terms of vol Out-of-the-money options quoted using benchmark of 25 delta implied volatility 7

8 GBP/USD spot Latest: (weekly) Source: Bloomberg LP 8

9 GBP/USD 3 month implied volatility (at-the-money) Latest: 5.50% (weekly) Source: Bloomberg LP 9

10 GBP/USD 3 month 25 delta risk reversals Latest: -0.37% (ie GBP 25 delta call is 0.37% cheaper than equivalent GBP 25 delta put) (weekly) Source: Bloomberg LP 10

11 Value Opportunities GBP/USD fell heavily from July and particularly October 2008 until low in January 2009 Implied volatility for at-the-money options predictably rose sharply to 25% peak in November delta risk reversal offered cheaper downside protection than at-the-money options in late 2008 But risk reversal then offered much cheaper upside cost versus underlying FX forward in 2009 recovery 25 delta calls 2.0% 3.0% cheaper than equivalent 25 delta puts in most of Q delta risk reversals offered cheaper GBP calls v GBP puts until June 2009, before spot 1.70 peak Offered choice of lower GB call strike, lower GBP put strike or upfront net premium gain 11

12 Charting Opportunities Major part of GBP/USD recovery since 2009 started in May 2010 Few obvious charting signals in GBP/USD chart of new, gradually rising trend 25 delta risk reversal chart identified end of major trend exhaustion in May 2010 (-4.0%) TD Sequential 13 on monthly chart signalled end of trend decline since +0.70% peak (December 2006) Risk reversals often trade at variance from underlying spot market Often used aggressively to hedge highly mathematical exposures from exotic option structures Technical analysis identifies extreme risk reversal moves and potential implications for spot market 12

13 GBP/USD spot Latest: Source: Bloomberg LP 13

14 GBP/USD 3 month implied volatility (at-the-money) Latest: 5.50% (weekly) Source: Bloomberg LP 14

15 GBP/USD 3 month 25 delta risk reversals Latest: -0.37% (ie GBP 25 delta call is 0.37% cheaper than equivalent GBP 25 delta put) (monthly) Source: Bloomberg LP 15

16 DISCLAIMER This presentation does not constitute or imply an offer or commitment whatsoever on the part of Lloyds Bank plc. Any such offer may only be made after the negotiation of satisfactory documentation and only after appropriate credit authority has been obtained. The pricing discussed herein is based on our view of current market conditions and is for discussion purposes only. This presentation and all ancillary documents relating to it (together the "Presentation") was prepared by Lloyds Bank exclusively for you for the purpose of analysing certain potential transactions. The Presentation is being made available on a strictly confidential basis to you and is intended only for the internal use of authorised recipients ( Recipients ) and no part of it may be disclosed to any third party. This Presentation and the information contained herein are the property of Lloyds Bank. Recipients are hereby notified that photocopying, scanning, or any other form of reproduction, or distribution - in whole or in part - to any other person at any time is strictly prohibited without the prior written consent of Lloyds Bank. The information in this Presentation reflects prevailing conditions and our judgment as of this date, all of which are subject to change or amendment without notice and the delivery of such amended information at any time does not imply that the information (whether amended or not) contained in this Presentation is correct as of any time subsequent to its date. Whilst Lloyds Bank have exercised reasonable care in preparing this presentation and any views or information expressed or presented are based on sources they believe to be accurate and reliable, neither Lloyds Bank, nor any of their officers, servants, agents, employees or advisors make any representation or warranty, express or implied, as to the fairness, accuracy, adequacy, completeness or correctness of such information, nor as to the achievement or reasonableness of any projections, targets, estimates, or forecasts and nothing in this Presentation should be relied upon as a promise or representation as to the future. Neither Lloyds Bank nor any of their officers, servants, agents, employees or advisors or any affiliate or any person connected with them accepts any liability whatsoever for any direct, indirect or consequential damages or losses arising from any use of this Presentation or its contents or otherwise arising in connection therewith. Lloyds Bank undertakes no obligation to update or correct any information contained herein or otherwise to advise as to any future changes to it. Applicable tax, accounting and legal considerations are subject to change and in all cases independent professional advice should be sought in those areas. This Presentation is provided for information purposes only: there has been no independent verification of the contents of this Presentation. It does not constitute or contain investment advice. It is not and shall not be construed as an offer, invitation, recommendation or solicitation to sell, issue, purchase or subscribe for any securities in any jurisdiction or to enter into any transaction. It is not and shall not be construed as an offer to arrange, underwrite, finance, purchase or sell any security, financial instrument, assets, business, or otherwise provide monies to any party. Such offers may only be provided in writing after satisfactory legal, financial, tax, accounting and commercial due diligence, as well as approval from the relevant business and credit committees of Lloyds Bank and/or their affiliates. The information contained in this Presentation is in summary form for the convenience of presentation and may therefore not be complete. Products and services that may be referenced in the Presentation may be provided through affiliates of Lloyds Bank or any person connected with them. Lloyds Bank and their affiliates prohibits employees from offering a favourable research rating or specific price target or changing a rating or target to get a mandate and Lloyds Bank and their affiliates prohibit research analysts from being compensated for involvement in investment banking transactions, except to the extent that such participation is intended to benefit investor clients. Lloyds Bank, their affiliates, their respective directors or officers or persons connected with them may have an interest in any financial instrument mentioned in this Presentation. Lloyds Bank is a trading name of Lloyds Bank plc and Bank of Scotland plc. Lloyds Bank plc. Registered Office: 25 Gresham Street, London EC2V 7HN. Registered in England and Wales no Bank of Scotland plc. Registered Office: The Mound, Edinburgh EH1 1YZ. Registered in Scotland no. SC Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority under registration numbers and respectively. 16

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