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The Bridge Between Spot Forex and Options
Submitted by Tradervox on Sat, 25/09/2010 - 20:57
Although it is possible to trade the spot market exclusively, many traders prefer to include some kind of analysis of external factors into their strategies and analysis with the intention that a greater array of data sources will lead to more precise and reliable signals in trading. That the forex market
lacks a volume component tracked by a central exchange or authority also compels many traders to seek this type of information in the data supplied by the activity in the periphery of the spot market, such as options, forwards, or futures.
To recall the basic facts about options, let's remember that a put option contract grants the purchaser the right to sell an underlying asset at a specified strike price, at a predetermined point in the future, in exchange for a fee termed the premium. Similarly, a call option grants the purchaser of the contract the right to buy the underlying asset under terms parallel to the case of the put option.
Both types of option contracts are widely available for most kinds of currencies, and change hands as part of the general activity in the commodity markets.
The purpose of the retail trader who examines the records of the options market is deriving an equivalent for the volume data of the stock and bond markets, for instance, but needless to say many other approaches and methods are also possible with the same tools.
The put/call ratio is quite simply the ratio of all outstanding put option contracts in a particular currency pair to the number of all call option contracts in the same. Thus, if a larger number of traders believe that an asset will lose value, and that sell options will be more profitable over the short term, the ratio of puts to calls will rise, leading the put/call ratio to rise above 1.
When traders are bullish and expect buy-side contracts to perform well, they will instead purchase call options, leading the put/call ratio to fall below 1, and indicating traders' bias to the bullish case.
This indicator can be used for two purposes. One is the identification of market extremes. A study of prices, and their comparison with options market data would show that the long-term highs and lows in the spot market often coincide with extremes in the put/call ratio, since both are representative of the overall bullish or bearishness of traders.
Thus, traders can anticipate reversals at points where the put/call ratio is testing a previously established extreme value. Another way to make use of the put/call ratio is to use it as a volume indicator.
In this case, we can consider the ratio to reflect the relative bullish/bearishness of the market on the basis of volume data, and it can then be incorporated into many different strategies that would require a volume indicator for their creation.