Trading Brief: Australian Dollar Futures Options made a $120 profit, a return of 15.3% in 1 day

AUD FOP brief will explore the double derivative nature of slightly complex instruments called Futures Options / Options on Futures. We will dive into payoff profiles, risks involved, and potential underlying dynamics to be aware of and manage risk accordingly. Our internally derived probability metric for this perspective is above 80% and was therefore alerted in the group yesterday. Let us analyze its profit outcomes and perceived actions for the future.

Briefing Date: Jan 07, 2024

Market Focus: Equities & Options (US)

Time Horizon: 1 week (currently closed)

Distribution Time: Post-Market

Market Overview

Stock and bond prices fell after higher-than-expected job openings and business costs sparked inflation fears. The Labor Department reported 8.1 million open positions at the end of November, indicating a stabilized labor market. Investors sold off stocks, with Nvidia and Tesla pulling down major indexes, while bond yields continued to rise, with the 10-year Treasury yield nearing 4.7%.

The Nasdaq Composite and S&P 500 declined in recent trading, while the Dow wavered. Meta's shares dropped after the company announced it would end fact-checking on Facebook and Instagram. Overseas markets saw gains in Europe and a boost from chip stocks in Japan's Nikkei 225, although Tencent's decline affected Hong Kong's Hang Seng. Oil prices also climbed, with benchmark U.S. crude futures increasing over 10% in the past month.

The dollar is strong, but the currencies trading against it, such as AUD, CAD, GBP, EUR, and precious metals like Gold and Silver, have had lackluster performance lately. As the dollar retreated, all the above, mainly Australian and Canadian dollars, were looking for an upward surge. With the Canadian PM resigning, the market expects the new incoming administration to reverse his policies, supporting domestic sentiment and lifting the CAD.

AUD mainly formed a strong technical pattern we exploited yesterday with a bullish perspective shared in our community. We selected the futures instrument for a quick option spread deployment.

Chart

In our experience, signals and analysis are easier with less noise on a higher time frame. We started our analysis as usual, with monthly, weekly, daily, and 4-hour intervals in that order of descent.

The above chart overlays a one-day time frame for Australian Dollar Futures expiring in January (the front month). However, the price differentials are minimal, and the February series will mimic the pattern as well, so January futures become the specimen of choice for our analysis.

Key points to consider:

1. Strong support at the bottom is indicated in the blue horizontal line

2. Bullish divergence between MACD and price indicated in the green line

3. There is also a crossover of MACD on the weekly time frame, indicating a potential reversal formation in a downtrend

Once we form structural grounding, it is natural to expect an upward move in the Aussie's currency markets after a weeks-long sell-off. We intend to exploit this with an option spread that gives us net credit for selling upfront and wait for the upward move to manifest so that the options we sold lose extrinsic value inherent in them as time passes (theta) along with the direction (delta). We typically choose a defined-risk strategy that is safe for retailers. The Bull Put Spread is our choice because it reflects a bullish perspective. We traded Options on Futures, which is called a double derivative position. This is a prevalent trade among Institutions but less common among the retail segment. Let us look at the trade analysis.

Trade Analysis

Underlying: Australian Dollar Futures February Series

Asset Class: Futures Options (aka options on futures)

Instrument: Put Credit Spread (aka Bull Put Spread)

Trade alert sent in Strats Labs workspace

We sent out the above alert in our community workspace yesterday. Following is a detailed overview for beginners of the instrument - Futures Options.

Short (STO) AUD Feb 07 0.6250 Put

You receive a premium, which is a credit to your account.

Long (BTO) AUD Feb 07 0.6225 Put

You pay a premium, which is a debit to your account.

Net Credit: -$0.00120 (or $120 since Australian Dollar futures contracts are typically quoted in terms of 100,000 AUD per contract). One futures contract represents AUD 100,000.

Maximum Profit

Maximum profit occurs if the Australian Dollar futures price is above the short put's strike price (0.6250) at expiration. Both options expire worthless. Max Profit = Net Credit = $120.

Maximum Loss

Maximum loss occurs if the Australian Dollar futures price is below the long put's strike price (0.6225) at expiration. In this case, the loss is capped by the difference between the strikes minus the credit received. Max Loss = (Strike Difference - Net Credit) × Contract Size. Max Loss = (0.6250 - 0.6225 - 0.00120) × 100,000 = 0.00130 × 100,000 = $130.

Breakeven The breakeven point is the point where the credit offsets the loss on the short put. Breakeven = Short Put Strike - Net Credit Breakeven = 0.6250 - 0.00120 = 0.62380.

The margin requirement for a vertical spread (both credit and debit spreads for call and puts are called verticals) is typically the maximum loss of the trade because the risk is defined. This means the broker will require you to maintain a margin equal to $130.

Payoff Profile

At expiration:

• If the futures price is above 0.6250, both options expire worthless. You keep the credit of $120.

• If the futures price is between 0.6250 and 0.6225, the short put will have some intrinsic value, and the long put will offset part of that loss.

• If the futures price is below 0.6225, the long put offsets the short put, and your maximum loss is capped at $130.

Futures Price	Short Put P/L	Long Put P/L	Net P/L
Above 0.6250	$120 (credit)	$0	$120
0.6240	-$10	$0	$110
0.62380	-$20	$0	$0 (B/E)
0.6225	-$250	$250	$120
Below 0.6225	-$250	$250	-$130

In a nutshell

• Max Profit: $120

• Max Loss: $130

• Breakeven Point: 0.62380

• Margin Requirement: $130

How did we make a profit and future outlook?

As can be seen from the alert picture above, we got a credit of $120 per contract and closed the position as the premiums for the spread dropped to $100 as a mid-price. The $20 profit per contract is sufficient for us, and we exited. We did six contracts making $120 profit (excl. commissions).

The future looks strong in the near term, and we expect AUD to rise towards 0.63000 against the dollar. It can surge even higher, but since we are in an overall downtrend, we exercise caution and assign diminishing probabilities as we advance for this underlying rise upward.

Tips for Retail Traders when trading Double Derivatives

This is a double derivative and complex leveraged instrument, as Futures and Options are derived from the underlying Australian Dollar currency. Therefore, the risk and movements are significant, especially around elections, central bank rate decisions, and other macro events. Consequently, one must take immense care when trading these instruments.

Never trade Currency Futures directly, as the margin requirements are often $100,000 - $200,000 for one Futures contract. Consider trading options on these futures instruments using a defined-risk strategy. This means your maximum loss should be restricted to a fixed amount.

• Moneyness: We also trade deep-in-the-money options (ITM). Still, deploying only the at-the-money (ATM) or out-of-the-money (OTM) option spread is preferred to avoid unnecessary underlying assignments if the ITM options were exercised. In that event, you have to assume max loss, and the broker will take care of exercising the other option leg for you to offset the assignment that occurred from the other leg. The reason is that the underlying options here are Futures, which demand higher margins should an assignment occur, thereby triggering a potential margin call for our account. Just stick to ATM or OTM options for Futures Options.

• Variation Margin: Futures options often require margin adjustments based on market movements, unlike equities options where the margin is typically fixed for spreads.

• Implied Volatility: This is especially true if you deploy volatility strategies, but you must also monitor for defined risk spreads due to price differentials. Changes in IV can affect the value of futures options. Monitor IV to avoid entering trades when options are overpriced.

• Volatility Skew: Future options often exhibit a volatility skew (higher IV for out-of-the-money puts or calls), which can impact spread pricing. Just use three or 6-month IV charts to analyze which month expiry has a lower price and low IV. Weekly options aren't preferred due to poor liquidity. Beware of poor liquidity and avoid slippage (getting poor fills).

• Expiration and Rollovers: Futures contracts expire and may require rolling to the next month. Be aware of this; hence, always choose the underlying Futures expiry to be the same or higher than the option spreads. We call this Back Month futures. For example, we choose February futures, and our options expire on February 07.

• Correlation: Watch the correlation in the portfolio and ensure no other instruments are tied to the dollar. Understand how macroeconomic factors (e.g., interest rates, commodity prices) affect the underlying futures contract. We don't see any major news event coming from the Australian or US region (except for the US Jobs data today, which has a medium to low effect on AUD).

The above considerations are sufficient, but primarily, be aware of the Moneyness, sell ATM or OTM spreads, and always deploy defined-risk strategies only. Higher risk tolerances will blow out the account in one trade. Be highly aware of this one suggestion.

Closing Notes

This trade is made in our community workspace for an educational purpose only, and all participants must read and do their own research before trading such complex instruments. There are other considerations one must take care of if there are deviations from the practices mentioned above in this brief. All the material, examples, screenshots, and calculations are to be considered solely for educational purposes only, and this is not financial advice. Please read this options disclosure from the options clearing house OCC.