22 June 2011 at 13:35 GMT
Price action in the EURUSD spot market a few weeks ago got me thinking…thinking about a new tack of using options not independently but in combination with spot, and not in the traditional way of having them work as a stop loss or hedging mechanism. But rather instead as a way by which to participate on an intraday basis. Now bear with me as I try to articulate what in essence is a relatively uncomplicated strategy/method, but as with most things the devil is in the detail….
Here’s a quick replay of what happened on June 2: the EURUSD ran up (early doors) to the previous night's overnight high from the morning open, 1.4485. To me this was a sell and thus I did so, placing my stop above the 1.4535 level, looking for a move lower into 1.4400 and beyond to test the 1.4380 zone. Now for the first 20/30 mins or so this looked as I like to call it, all apples, as the move was faded by the wider market and I found myself about 30 or so points in the money on my spot position. But as is often the case the price action told me something entirely different, which was that we’d found a small base here (1.4440/50) and were likely for the next hour or so to have another look higher thus eroding my thus far 30 point profit back to entry levels. Now at this stage I still had my conviction for a move lower on the day but thought I don’t want to be closing my spot position here, just in case… The retail trader mentality rearing its ugly head… I don’t want to take a measly 30 points when anticipating at least double that but I also don’t want to see money already earned eroded away. So what do I do?
Well the answer came to me as I was walking the dog that night (as often most answers come to me, after deep consultation with my four legged best mate), why not at the 1.4440/50 level, 30 points in the money on my spot position, buy an overnight at the money (ATM) Call on EURUSD, all the while keeping my spot position open with its related stop order still in place. Now most of you would be thinking that this was hardly a revelation and that my dog should likely have a closer look at spot/option theory before espousing on the topic. However, he’s not as dumb as most of you think, and, here is why. Engaging in the above mentioned play allows you to have two open positions (almost both spot in nature) in opposite directions without being entirely hedged.
The logic here is relatively simply, I believed that spot was still going to come lower on the day but for the next however long we’d grind higher, so why not try to make money on both moves. If the nominal on both positions is equal in size with an ATM option being a 50 delta you’re not completely hedged or delta neutral, it also means that for every 2 point move in the spot there is a 1 point change in the value of the option, thus 50 points higher in the spot market means a 25 point gain on my Call option while leaving me 20 points out of the money on my spot position. I don’t encounter the sadness of having given money back to the market on spot and instead use the opportunity sell out my long ATM option as the market turns back to my original view.
In tangible terms if I execute this play successfully I keep my spot position open and ostensibly have improved my point of entry on that very same position by banking an extra 20 or so points profit on the option trade. This means I have not wasted an opportunity to make money while the market goes through its usual back and forth on any given day and better still have improved my overall risk/reward profile on the original directional play as all along I maintain my original stop order for the spot position where it was when I started out the day. Of course there is a spread in the ATM option to consider covering before you’re in the money, but the way the market has been trading lately, even with that in mind it shouldn’t be too hard to cover and profit from the forthcoming move.
So once again revising the above idea, you are able to have two separate positions (directionally opposed) open simultaneously, without being delta neutral, thus allowing for the opportunity to participate (profitably) in a whipsaw market, while maintaining your original view for the day.
So my dog isn’t as dumb as he looks now, is he?!
Of course maturities can be changed from overnight to a longer horizon, but hopefully you get the gist of where I’m going with this.
As always any and all questions/comments are appreciated and welcomed.