Trading forex (foreign currency) without any form of safety net, such as a stop loss, is suicide. However, a stop-loss used in a clumsy or random manner can turn a lot of your trades into losses. Many times your position will be stopped out, only to find it back in profit the next day. Of course, you’re not back in black, you already took a loss, and the position has been closed for you.
Alternative to a Stop Loss
There is a nice alternative, and it’s not so new. What is new, is the ability for even small investors to use it in their trading. Forex Options are a better safety net than stop losses. Until last year, we small investors couldn’t use them, or at least not easily. However, last year foreign currency options were listed for several major currency pairs, such as the ISE World Currency Options. You can trade these right now with your existing stock broker. A list of their symbols appears at the bottom of this article.
The options work the same as a Stop-Loss, by protecting your position from excessive losses, but is limited by time. It does not close your position when a set price is hit, but it protects you. You have time to wait for a market reversal. If no reversal comes, you take the loss, same as with a stop-loss. If a reversal does come, you now can enjoy the profit.
Last week the EUR/USD jumped to 1.3001 (a major resistance level), and I felt it would not break it. I shorted 10 positions at 1.3000 and bought 10 weekly call options on EUU (the symbol for the Euro/US dollar options) at .51 with 4 days left until expiration (strike price at 1.3000). Thus I spent $510, the same as a 51 pip stop loss. There was no way I could lose more than that $510, even if the EUR/USD soared to 1.3250 or beyond. In the following session, the EUR/USD collapsed to 1.2850. I had set a limit order to take profit at 1.2890, so my deal was sealed with $1100 profit, minus the $510 options, for a total $590 net profit. The beauty of that trade, is that I still owned the options for 3 more days. The next day, the EUR/USD rebounded to 1.2945 and I sold the call options for .11 getting $110 back. My total profit for the week = $700.
If you can handle a little more risk, you can buy your options further out-of-the-money. In my trade above, I could have bought 10 calls at the 1.3100 strike price for .07 instead, spending only $70. It would have been the same as a 107 pip stop loss, accepting $1070 in risk. However, my profit for that actual trade would have been greater, at $1030 ($1100 minus $70). It’s up to you – the level of risk you can accept.
On the previous week, I had a similar trade with EUR/USD at 1.2900, and it went against me, to 1.2977. With a stop-loss, I would had realized my loss, and the trade would have been over. Instead, I had 4 more days to get a reversal. Eventually by the end of the week, the EUR/USD was at 1.2865 and I close out my position with a $350 profit, minus the $520 option (.52 that week), netting a $170 loss. That’s a lot better than the $520 loss I would have realized with the stop-loss on Tuesday.
So why is an option better than a Stop-Loss?
With a Stop-Loss:
The position is closed when the SL price hits. The trade is dead. If it turns around, too bad.
However, it is not limited by time.
With an Option:
You have more time, a second chance for a market reversal
Still protected with limited risk
On a reversal, you can turn a loss into a profit.
However, it’s time limited.
Similar strategies can be used with the NADEX binary options.
Managing your losses will be key to your success in forex trading. Options are a better way to manage that risk. The most active symbols are: EUU (EUR/USD), GBP (GBP/USD), and YUK (USD/JPY). Check with the CBOE or ISE World Currency Options for a list of all the symbols, or ask your broker.
See Part II: Advanced Strategies with FX Options and Spot Forex
Top 2 Binary Options Strategies
The Pros and Cons of Trading Binary Options
Forex 5-Minute Scalping Strategy