What Are Pair Options

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Forex Option and Currency Trading Options

What are Forex Option and Currency Trading Options?

Forex options (also known as currency trading options) are securities that allow currency traders to realize gains without having to place an actual trade in the underlying currency pair. Forex options allow traders to pay a premium in exchange for the ability to profit from the moves of a currency block without holding or being held liable for that block. In this way, they can further leverage their currency trade and have the opportunity to magnify returns while limiting downside risk to the amount of premium paid.

Key Takeaways

  • Forex options allow traders to leverage currency moves, limit risk, and create higher potential gains.
  • Option pricing favors the seller so purchase options rarely pay out more than they cost over time.
  • Two types of options are offered known as Vanilla and Exotic options.

Understanding Forex Option and Currency Trading Options

Because forex option and currency trading options contracts implement leverage, traders are able to profit from much smaller moves when using options contracts than a traditional retail forex trade would allow. When combining traditional positions with a forex option, hedging strategies such as straddles, strangles, and spreads can be used to minimize the risk of loss in a currency trade. While this sounds good, an important caveat is that option pricing is mostly fairly priced, meaning there is a slight bias in pricing towards the seller. This bias makes it unlikely that options will pay out more than they cost or lose over time.

Not all retail forex brokers provide the opportunity for option trading. Retail forex traders who intend to trade options online should research prospective brokers because having a broker that allows you to trade options alongside traditional positions is valuable. However, traders can also open a separate account and buy options through a different broker. Because of the risk of loss involved in writing options, most retail forex brokers do not allow traders to sell options contracts without high levels of capital for protection.

There are two types of options available to retail forex traders for currency option trading: standard (vanilla) put and call options and exotic options.

Vanilla Options

The call option gives the buyer the right to purchase a currency pair at a given exchange rate at some time in the future. The put option gives the buyer the right to sell a currency pair at a given exchange rate at some time in the future. Both the put and call options are a right to buy or sell, and not an obligation. If the current exchange rate puts the options out of the money, then the options will expire worthless.

Standard options are known as ‘vanilla’ (or ‘plain vanilla’) since they are fairly straightforward, standardized, and do not contain any additional bells or whistles that more complex or exotic options contain.

Exotic Options

Exotic derivatives can also include single payment options trading (SPOT). Spot options have a higher premium cost compared to traditional options, but they are easier to set and execute. A currency trader buys a SPOT option by inputting a desired scenario (e.g. “I think EUR/USD will have an exchange rate above 1.5205 15 days from now”) and is quoted a premium. If the buyer purchases this option, the SPOT will automatically pay out if the scenario occurs. Essentially, the option is automatically converted to cash.

Additional types of exotic options may attach the payoff to more than the value of the underlying instrument at maturity, including but not limited to characteristics such as at its value on specific moments in time such as an Asian option, a barrier option, a binary option, a digital option, or a lookback option.

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Pairs Trade

What Is a Pairs Trade?

A pairs trade is a trading strategy that involves matching a long position with a short position in two stocks with a high correlation.

Understanding Pairs Trade

Pairs trading was first introduced in the mid-’80s by a group of technical analyst researchers from Morgan Stanley. The concept uses statistical and technical analysis to seek out potential market-neutral profits.

Market-Neutral Arbitrage

Market-neutral strategies are a key aspect of pairs of trade transactions. Market-neutral strategies involve long and short positions in two different securities with a positive correlation. The two offsetting positions form the basis for a hedging strategy that seeks to benefit from either a positive or negative trend.

Pairs Trade Strategy

A pairs trade strategy is based on the historical correlation of two securities. The securities in a pairs trade must have a high positive correlation, which is the primary driver behind the strategy’s profits. A pairs trade strategy is best deployed when a trader identifies a correlation discrepancy. Relying on the historical notion that the two securities will maintain a specified correlation, the pairs trade can be deployed when this correlation falters.

When pairs from the trade deviate, an investor would seek to take a dollar matched the long position in the underperforming security and sell short the outperforming security. If the securities return to their historical correlation, a profit is made from the convergence of the prices.

Pairs Trade Benefits

When a pairs trade performs as expected, the investor profits and also mitigate potential losses that would have occurred in the process. Profits are generated when the underperforming security regains value, and the outperforming security’s price deflates. The net profit is the total gained from the two positions.

Limitations of Pairs Trades

There are several limitations for pairs trading. One is that the pairs trade relies on a high statistical correlation between two securities. Most pairs trades will require a correlation of 0.80, which can be challenging to identify. Second, while historical trends can be accurate, past prices are not always indicative of future trends. Requiring only a correlation of 0.80 can also decrease the likelihood of the expected outcome.

Correlation Convergence

To illustrate the potential profit, consider Stock A and Stock B, which have a high correlation of 0.95. The two stocks deviate from their historical trending correlation in the short term with a correlation of 0.50. The arbitrage trader steps in to take a dollar matched the long position on underperforming Stock A with a short position on outperforming Stock B. The stocks converge returning to their 0.95 correlation over time. The trader profits from a long position and closed short position.

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