If you have already traded options on equities but are now looking for a new asset class, you might be wondering if it is possible to blend exposure to interest rates, commodities, cryptocurrencies, geopolitics, and the global economy.
In fact, you have just described the foreign exchange (FX) market and, in particular, options on the U.S. dollar versus the Canadian dollar (trading on Montréal Exchange under the symbol USX). Here follows an overview of the foreign exchange market, plus a few options strategies to consider when trading USX.
The market goes by several names—currencies, currency pairs, exchange rates, foreign exchange, forex, FX—but whatever you call it, each currency “pair” is a ratio: the value of one nation or bloc’s currency relative to that of another.
On average, over $5 trillion of foreign exchange changes hands every day. Major currency pairs including the dollar (CAD), U.S. dollar (USD), British pound (GBP), Japanese yen (JPY), euro (EUR), and others are dynamic and liquid. Before we jump into the specifics of USX—call and put options on the value of USD in CAD terms—it is important to understand a few FX basics.
FIGURE 1: INVERSE CORRELATION. Strength in USD-based crude oil (purple line) is correlated with CAD (and inversely correlated to the USD/CAD currency pair). Chart source: TradingView.
If you are considering trading FX, you will want to understand how it differs from equities. First, currencies tend to be mean-reverting. That is trader-speak for the fact that, although currencies have trends and cycles like stocks, stocks generally appreciate over time. Currencies tend to ebb and flow around a band.
If you trade equity options, you know that implied volatility is typically skewed to the downside. Because stocks gradually rise by default—with occasional panic-driven meltdowns—, downside put options tend to trade at a higher level of implied volatility. Some traders say stocks take the stairs up and the elevator down.
In contrast, perishable commodities tend to skew upward, as traders fear and therefore avoid potentially running out of a commodity. This is not always the case, but it is a general tendency.
In the FX market, skew can fluctuate depending on current supply/demand dynamics. But in general, USX options—based on USD/CAD—usually skew slightly toward upside calls.
Another difference between USX and equities is contract size and the minimum fluctuation (or “tick”). Equity options contracts use 100-share increments. The contract size of a USX option is USD 10,000, and the tick size is 0.01 Canadian cents. So the USX option feels similar to an equity option in how the option’s premium translates into dollars. For example, an options premium of CAD 1.25 equals CAD 125 in notional terms. For the full USX contract specs, refer to the fact sheet.
Now for similarities. If you are comparing USX options to equity options, you should know that the same basic math applies to both. The software used to calculate theoretical values, delta, vega, and the rest of the risk metrics you might follow (collectively known as “Greeks”) works in the same way.
The same can be said of options strategies—calls and puts, bullish and bearish strategies, and any spread you might want to put on—the mechanics are the same, whether it is on an equity derivative or a currency derivative.
Even given the similar strategy mechanics, some strategies are well suited to currency markets. Not only do currencies tend to revert to the mean, they also tend to trade at lower implied volatility than equities. Here follows an overview of options strategies for mean-reverting, low-volatility products.
FIGURE 2: LONG CALENDAR SPREAD. The max profit point of a calendar is at the strike price on the expiration date of the front leg. Be sure to liquidate or roll, either on or before that first expiration.
The bottom line: If you are looking for a new type of asset class to trade, and you have a view on the interest rate or commodity markets, consider options on the U.S. dollar (USX). You can use the same options strategies you employ in the equity options market, but with targeted exposure. Interested in learning more about these and other options strategies? Look into our regularly scheduled educational events.
Disclaimer:
The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.
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