Volatility trading in forex is trading the volatility of a currency pair's price movements instead of the price itself. Volatility is the measure of how drastically the market prices move.
A more sophisticated hedge is buying volatility. As the market becomes more uncertain, so does volatility. Using several calls and puts options, one can go long or short in volatility. In effect, you are creating a wide margin of protection from directional movement.
This hedge requires a combination of option calls and puts and therefore is only suitable for savvy investors.
As a non-directional trade, buying volatility only requires the currency pair to remain within a spread to be profitable.
This strategy requires multiple options and therefore, can be expensive when compared to other approaches.
An investor believes AUD/USD will remain steady over the next two months. It is currently trading at $0.76. As a precaution, they decide to implement an iron condor, an options hedge strategy to buy volatility.
As illustrated by the steps below, this approach profits when the currency pair you are trading stays within the two upper and lower spread positions.
|1. Sell a Call||$0.85||$0.13|
|2. Buy a Call||$0.92||-$0.15||$0.77|
|3. Sell a Put||$0.90||$0.20|
|4. Buy a Put||$0.72||-$0.12||$0.50|
The total credit for this strategy is $1.27 ($0.77 + $0.50). For one contract (100 pairs), the total is $127. This figure represents the maximum profit.
If the AUD/USD pair price remains between $0.85 and $0.90 when the expiration occurs in two months, the maximum profit will occur. However, if the price goes above $0.85 or below $0.90, this investor will have reduced or negative returns.
© 2020 Todd Moses
The strategies discussed are for illustrative and educational purposes and are not a recommendation, offer, or solicitation to buy or sell any currency or to adopt any investment strategy. There is no guarantee that any strategies discussed will be useful. Todd Moses is not a licensed securities dealer, broker, or US investment adviser or investment bank.