You must have heard that forex is the most liquid market in the world. Perhaps that explains your interest in the market. Also, you must be aware that there are various ways of trading forex. These include currency futures, currency options, and currency ETFs, and spot forex markets. Of these, the most popular, and most liquid, is the spot forex market. This is where you and many other retail traders belong.
For starters, all four major forex markets are intertwined. This means that whatever happens in one market reverberates across all other currency markets. For example, events in the currency options market could increase or decrease volatility in the spot forex markets. This article dwells on the relationship between the spot forex market and the currency options market. Particularly, the article focuses on gamma scalping trades in the currency options market and their significance to retail spot forex market traders. In this article, the forex market will refer to the spot forex market.
Currency options market, how it operates
One of the many forex trading secrets is to get detailed information about the entire currency market. You do not have to participate rather, knowledge might be helpful when designing trading strategies using different technical indicators. Accordingly, it is imperative to understand how the currency options market operates. This way, you will easily understand gamma scalping trades and how they influence the forex market.
Currency options trading is a derivative of the forex trading market. Here, traders buy the rights to buy or sell an asset (a currency pair) after a specific time. A call option is a buy contract while a put option is a sell contract. The price at which one is to exercise the option is the strike price. Since this market is influenced by the same factors that influence the forex market, traders use common forex charting tools to conduct market analysis.
Specifically, four concepts reign supreme in the currency options market. In the first place, there is a delta. This represents the change in the value of an option with changes in the underlying asset. Secondly, there is gamma (our focus for this article). Gamma is a function of delta in that it shows the impact of the changes in an underlying asset’s price on the delta of an option. Thirdly, theta shows the time decay of a currency option. Lastly, Vega shows the impact of the change in the implied volatility of an underlying asset on the value of a currency option.
Gamma scalping trades
Gamma trading is a reserve of market makers, that is, traders who have enough capitalization to influence the direction of the market. These are traders who, besides having access to the best forex indicators in the market, they have advanced trading expertise. When these traders buy or sell options, they always hedge against risk. Typically, the traders opt for a delta-neutral strategy to compensate for the fluctuation of the spot rate of underlying currency pairs.
In options trading, the gamma for long options is positive but negative for short options. Therefore, a trader is likely to earn a good return if he goes long. However, the theta (time decay) aspect of the option dictates that an option loses value as it approaches the expiration time. This means the trader who goes long has to ensure that the gamma trade is worth more than the theta to break even.
For example, a trader goes long on the USD/JPY Call option. If the value of theta for this currency pair is, $250, the trader has to make sure that the gamma trade is more than $250 to earn a profit. Using another example, assume the same trader goes long gamma USD/JPY options. Say the value current price of the USD/JPY options is 104and the delta position of the portfolio is $5 million. If the USD/JPY climbs to 105, the new delta position will change to $10 million. This means the trader will have to sell $5 million of the underlying asset to hedge the delta position.
However, if the USD/JPY falls back to 104, the new delta position will decline to $5 million. To balance the delta and the gamma, the trader will have to buy $5 million resulting in a profit worth 100 pips. In a volatile market, this can go on and on as the trader changes from buying and selling while earning profit in the process.
If the trader is focused on scalping, he will not wait for big movements to earn 100 pips. Instead, he will focus on small movements that earn between 5 and 10 pips. In the process of adjusting the portfolio due to the changing delta position, the trader will be influencing the volatility of the USD/JPY pair.
How gamma scalping impact forex trading
Retail forex traders earn from the fluctuation of the interest rates of currencies within a pair. Due to the actions of gamma scalpers, currency pairs encounter a lot of volatility. Simply put, the rate of fluctuation for the currency pair increases. This makes the market more liquid. Further, the actions affect the ratio of implied volatility to the historical volatility of the currency pair.
Interestingly, the ratio of implied volatility to historical volatility is a great signal for entry and exit points in forex trading. If the implied volatility is smaller than the historical volatility of an option, then it indicates that the future price of the underlying currency pair could rise. For a trader that keeps observing this phenomenon, one will easily identify great trading opportunities.