Option overlays in the forex are a great way to control risk while taking advantage of the upside in trading. Options are a broad subject, so I’ll try to make the most of it here. We’ll be talking about two concepts that are quite common and can be executed easily and without constant maintenance.
A put is an option with three components. The first is a contract. When you buy a put, you are buying the right to sell someone the underlying currency at a predetermined price for a predetermined period of time. You could buy a put today to sell a lot of the GBP/USD at $4.0000 any time between now and a date you choose in the future.
If the currency pair falls to 3.9900, you can still sell it for 4.0000 and realize a profit. In fact, it doesn’t matter how far the currency falls. If it is still within your time window, you can sell the currency for 4.0000 at will. The set price (4.0000) that you have selected for your contract is known as the strike price.
The second component is time. Options are available in monthly increments. That means you can buy one that is good until next month or 10 months from now. The choice is up to you. Finally, options cost money. The price of an option is called the premium. The premium is higher the more valuable the options is. An option with a long time frame and a great strike price is more expensive than one with a very short time frame and a more speculative strike price. This strategy can appear to be slightly complicated at first, but it is worth learning more about it as it offers significant benefits. Institutional traders use option overlays, such as protective puts, all the time. It helps control risk and reduces total volatility in a portfolio. The benefits of this strategy are as follows.
You do not need to set a stop on your long currency position. How many times have you been right in your direction but got stopped out on a whipsaw in the market? I am positive that this happens to most forex traders on a regular basis. With a protective put, you are in charge and can let the exchange rate drop to zero, if that were possible, without exceeding your maximum loss. By the way, this benefit is also true during announcements. You are now in control.
Unlike many hedging strategies, this technique still allows for unlimited upside. Although gains are offset by the price of the put, gains can still be significant.
The total portfolio has lower volatility because your downside is capped. Here is an additional example. I will assume that pricing and volatility has been reasonably constant, on average, during the last 10 years and that your strategy is to buy a long position on the GBP/USD and an at the money put with total portfolio leverage of 20:1. That would have returned 10 percent per year during that period. When you combine this advantage with some prudent analysis, it is entirely possible to see much better returns than this.