T2W Trading Community

7. Controlling Risk

Risk may be controlled by setting stop losses (otherwise known as barriers) or by combining put and call positions to create limited risk/ limited profit and risk-averse volatility strategies

7.1 Barriers

• Out of the money knock out: An order to cancel a position (by taking an equal and opposite position) if spot moves through a set rate. The trigger rate is set below the strike rate for long calls and short puts, and above the strike rate for short calls and long puts
• In the money knock out: An order to cancel out a position if spot moves past a pre-set “in-the-money” rate. The trigger rate is set above the strike rate for long calls and short puts, and below the strike rate for short calls and long puts
• Double knock out: An order to cancel out a position if spot moves through one of two pre-set levels, one in the money and one out of the money.

7.2 Combinations

Currency option traders can combine the basic four option positions to manage risk: -

7.2.1 Limited risk limited profit trades

• Long call spread: A long call (lower strike rate) + short call (upper strike rate) yielding capped profit (when spot rises) and loss (when spot falls)
• Short call spread: A short call (lower strike) + long call (upper strike). Capped profit (when spot falls) and loss (when spot rises)
• Long put spread: A short put (lower strike) + long put (upper strike). Capped profit (when spot falls) and loss (when spot rises)
• Short put spread: A long put (lower strike) + short put (upper strike). Capped profit (when spot rises) and loss (when spot falls)

7.2.2 Risk-averse volatility trades

With volatility trades, we do not care about the direction in which the spot price moves. We are merely concerned with the magnitude of the movement.

• Long Straddle: A long call + a long put at the same strike rate. Unlimited profit when spot is rising and significant but limited profit when spot is falling. Maximum loss is limited to the sum of the premiums. To be profitable, the spot rate must deviate from the strike rate by more than the sum of the premiums (market neutral and bullish volatility).
• Long Strangle: A long put (lower strike) + a long call (upper strike). Unlimited profit when spot is rising. Significant but limited profit when spot is falling. Maximum loss is the sum of the premiums paid. To be profitable the spot must rise beyond the upper strike rate or fall below the lower strike rate by at least the sum of the premiums (market neutral and bullish volatility).

Straddles and strangles may be combined to produce other risk-reducing combinations, e.g.

• Long iron butterfly: A long straddle financed by a short strangle with strike prices above and below the long straddle strike rates (neutral direction and bullish volatility) Short iron butterfly: A long strangle financed by a short straddle and the inverse of the long iron butterfly. (Neutral direction and bearish volatility Long iron condor: A long strangle + a short strangle with strike rates above and below the long strangle strike rates (neutral direction and bullish volatility).
• Short iron condor: A short strangle + a long strangle with strike rates above and below those of the short strangle (neutral direction and bearish volatility).