TECHNICAL ANALYSIS IN FX OPTIONS FOR DIRECTIONAL FX TRADING Tim McCullough July 2014
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
Trading FX via FX forwards versus FX options GBP/USD example Spot: 1.7044 3 month forward: 1.7030 (spot 1.7044 3 month forward points 0.0014) Buy 3 month GBP/USD FX forward: contract to buy GBP / sell USD at 1.7030 3 months from now No flexibility but no premium payable Buy 3 month GBP/USD 1.7030 GBP call option Right to buy GBP at 1.7030 in 3 months time, but can walk away if GBP/USD < 1.7030 at expiry Pay upfront premium, equivalent to GBP/USD 0.0193 Profitable if GBP/USD > 1.7223 at expiry (1.7030 + 0.0193 premium paid) Sell 3 month GBP/USD 1.7030 GBP put option Obliged to buy GBP at 1.7030 in 3 months time, if GBP/USD < 1.7030 at expiry Receive upfront premium, equivalent to GBP/USD 0.0193 Profitable if GBP/USD > 1.6837 at expiry (1.7030 0.0193 premium received) 3
Payoff Profiles: FX forward versus FX call & put options GBP/USD P & L 0.15 0.1 0.05 0-0.05-0.1-0.15 1.55 1.60 1.65 1.70 1.75 GBP/USD at expiry 1.80 1.85 GBP/USD 0.15P & L 0.1 0.05 0 GBP/USD forward Unlimited P & L around 1.7030 forward level Buy GBP call option Unlimited profit > 1.7223 breakeven level Limited loss = GBP/USD 0.0193 premium paid -0.05 1.55 1.60 1.65 1.70 1.75 1.80 1.85 GBP/USD at expiry GBP/USD 0.05 P & L 0 1.55-0.05 1.60 1.65 1.70 1.75 1.80 1.85-0.1 Sell GBP put option Limited profit = GBP/USD 0.0193 premium received Unlimited loss < 1.6837 breakeven level -0.15 GBP/USD at expiry 4
Trading FX risk reversals as proxy for FX forwards GBP/USD example Spot: 1.7044 3 month forward: 1.7030 (spot 1.7044 3 month forward points 0.0014) Buy 3 month GBP/USD 1.7350 GBP call option (25 delta) Right to buy GBP at 1.7350 in 3 months time, but can walk away if GBP/USD < 1.7350 at expiry Pay upfront premium, equivalent to GBP/USD 0.0070 and simultaneously Sell 3 month GBP/USD 1.6700 GBP put option (25 delta) Obliged to buy GBP at 1.6700 in 3 months time, if GBP/USD < 1.6700 at expiry Receive upfront premium, equivalent to GBP/USD 0.0070 Net premium = zero (as in FX forward) 5
Trading FX risk reversals as proxy for FX forwards GBP/USD P & L 0.1 0.05-0.05 0 1.55 1.60 1.65 1.70 1.75 1.80 1.85-0.1-0.15 GBP/USD at expiry Unlimited profit if GBP/USD > 1.7350 at expiry Unlimited loss if GBP/USD < 1.6700 at expiry Zero profit or loss if GBP/USD between 1.6700 1.7350 at expiry 6
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
GBP/USD spot Latest: 1.7044 2007-2014 (weekly) Source: Bloomberg LP 8
GBP/USD 3 month implied volatility (at-the-money) Latest: 5.50% 2007-2014 (weekly) Source: Bloomberg LP 9
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) 2007-2014 (weekly) Source: Bloomberg LP 10
Value Opportunities GBP/USD fell heavily from July and particularly October 2008 until 1.3503 low in January 2009 Implied volatility for at-the-money options predictably rose sharply to 25% peak in November 2008 25 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 Q1 2009 25 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
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
GBP/USD spot Latest: 1.7044 2007-2014 Source: Bloomberg LP 13
GBP/USD 3 month implied volatility (at-the-money) Latest: 5.50% 2007-2014 (weekly) Source: Bloomberg LP 14
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) 2007-2014 (monthly) Source: Bloomberg LP 15
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