This chapter focuses on how to find direction for a forex option trade and details the importance of several factors, such as interest rate expectations, the role of federal funds futures, and finding the probabilities of Federal Open Market Committee (FOMC) decisions. In addition, you will find an introduction to the binary options on the FOMC decisions as well as instruction on using housing sector data for developing forex option direction decisions.
THE IMPORTANCE OF INTEREST RATE EXPECTATIONS
Of major importance to the forex option trader is anticipating interest rate decisions by central banks. Of all of the factors moving currency prices, this is the most important and will be discussed in greater detail later in this book. The following column appearing in Bloomberg is a typical example of commentary throughout the year regarding interest rates and a currency direction.
HOW TO ANTICIPATE THE DIRECTION OF THE FEDERAL OPEN MARKET COMMITTEE (FOMC)
It’s all about the central bank’s role to increase or decrease interest rates. Technically, we mean the action the FOMC makes on the federal funds rate at its meetings. These are the interest rates paid on loans made between banks (also known as depository institutions).The market forms an expectation about the next central bank decision on interest rates. This expectation then governs the sentiment between central bank meetings.
So the first thing that a trader needs to do is to group the world of currencies into three groups: currencies with interest rates expected to go up, currencies with interest rates expected to go down, and currencies with interest rates expected to stay the same. The forex trader must consider these correlations between interest rate expectations and direction in shaping the duration of the trade.
If the option trade extends beyond a central bank decision window, then the trader needs to anticipate a future meeting decision. There are now very effective ways of anticipating FOMC decisions that we will demonstrate in the next section.The Role of Federal Funds Futures What is the probability of a specific interest rate decision by the FOMC? How can the trader answer this question and go beyond just guessing?
Answering this question is the focus of a great deal of work throughout the world. For the readers of this book however,there is a very effective way and it is in fact supported by official Federal Reserve Bank analysis. The Federal Reserve Bank of Cleveland stated, “Options on federal funds futures can be analyzed to extract public expectations of future Fed actions.
”The Federal Reserve experts have developed a very sophisticated method for calculating the probability of FOMC actions that a reader interested in quantitative methods would consider worthwhile to review.The CBOT Binary Options: Using Binary Option Prices to Get Market Expectations of FOMC Decisions The importance of anticipating currency direction we have said is paramount to the forex option trader.
So our focus here is on presenting the best direct tool for enabling the trader to get an informed opinion about what the FOMC will do and also actually trade the FOMC decision directly! The forex option trader is very fortunate because the federal funds contract has a revolutionary option on it—binary options traded on the CBOT. It’s important to note that understanding how these options can provide the trader.The federal funds rate is targeted by the FOMC. The target is converted into an option strike price. So a target of 4.00 percent gets converted to 100 – 4.00 or 96.00 strike price.
In other words, the trade gets strike prices that allow an anticipation of what the FOMC meeting will do.Interpreting the Binary Options:The binary option is on the underlying federal funds rate directly. This contrasts with options on the average federal fund rate. The contracts also cover the next four meetings, so it provides a longer time frame as well. Also there is no other outcome.
The trader either gets 1000 or gets 0. In a regular option purchase, the risk is limited to the premium paid, but the gain can vary. Figure 3.3 compares the payout under the binary option or a call. We can see that the binary option limits the payout. A major advantage is that the binary option also limits the risk on writing the option.
A trader can in effect play the house and write an option and have no further risk other than owing the difference between what the trader receives (premium paid by the buyer) and 1000.The strike prices are then subject to being bought or sold (written). If the trader writes a call at a strike price of 96.00, he is betting that the rates will not go down.