TODAY Greece goes to the market with a €6bn (£4.8bn) bond auction. The country is looking to pick up sufficient funds to pay back the €5bn that falls due on Friday. Although the budget cuts that were approved on Sunday should be enough to release another tranche of emergency aid, there’s still the outside possibility that the unmentionable could happen on Friday – Greece defaults on its debt.
This would send shockwaves through financial markets. The euro would arguably face very heavy selling as a result. If Greece goes, which fringe state could follow next and does that leave a whole house of cards ready to tumble to the ground? Although the euro-dollar may be trading at around $1.2710 presently, a default would have the potential to send this significantly lower. In contrast, the generally expected outcome – that the debt is repaid and the wheels keep turning – would leave the same currency pair climbing higher, on the assumption that traders can find some optimism on the back of this news.
So how can you position yourself to take advantage of a market movement like this? A normal short bet on euro-dollar would see you losing out and potentially quite quickly - if the debt is repaid and the euro rallies. But financial markets are fortunately a little more sophisticated, and you could exercise a widely-used instrument known as the option. This, in other words, gives you the right – but not the obligation – to trade an underlying asset at a pre-determined price at some point in the future. This particular Greece example refers to a currency pair, but options can be applied to a wide range of assets. Options markets are full of jargon, but here is an example of how to apply an option to an actual trade.
If you believe that euro-dollar is going to fall, you could buy a put option, giving you the right to sell euro-dollar at a pre-set price in the future. The cost of buying these options (the premium) is calculated using a sophisticated model that takes into account a number of factors – including the time until the expiry of the trade and the volatility of the underlying asset. To sell euro-dollar at a strike price of $1.2600, for example, with an expiry of 21 November, the premium would amount to $252 (£158). The longer the time until expiry, or the more volatile the underlying asset, the higher the premium would be.
Let’s say that the euro plummets to $1.2500 on Thursday night. You can trade out of the option at any time you want, and for each pip below the strike price assigned in the option – in our case $1.2600 - you stand to make $10. At $1.2500 the move is 100 pips, so the profit would be $1,000, minus the $252 premium paid for the option. The total balance would therefore be US$748. Should the move be less pronounced on the downside – say euro-dollar only trades down to $1.2580 by expiry – although you settle 20 points beyond the option price (giving a profit of $200), you paid an initial premium of $252, resulting in a final loss of $52. So long as you trade out of the option – or the option expires - when the price is lower than $1.25748, your premium will be covered and you will make a profit. In the rather descriptive words of option traders across the globe, you’re “in the money”.
Trading foreign exchange options does come with one key advantage. If the market moves against you, your losses are always capped at the initial premium paid. Furthermore, any underlying market volatility while the option is running won’t have any adverse impact – the position won’t be stopped out.
This brief introduction is merely scratching the surface of trading with options. In addition to the put described above, if you think the underlying asset will increase in value you buy a call option. Combine the two and you get a straddle. This means that, as long as the underlying instrument moves far enough in either direction, you’re back in the money. The list goes on from here and the subject is one certainly worth returning to in the future.
13 November 2012 12:21am
by Neal Gilbert