Forex can be traded both in the spot and the futures market, and options play a significant role in determining prices at periods stretching father than the real time of the spot. If you’re an options trader, you’re already familiar with what a put and a call is, and what the put/call ratio signifies with respect to trading decisions. A put is a contract to sell a quantity of the underlying commodity, or stock, and a call is a contract to buy. Let’s note that the contract only gives you the right, but never the obligation to buy or sell the contract. The price of the option is the premium you pay to purchase that right. It is called the option premium.

So what is the relationship of options trading and forex. First of all, the options market often mirrors the spot market in terms of overall bullishness across the term structure, and the traders in forex options are often the same people who trade the spot market. It is commonplace to see a large speculator hedge against a spot buy or sell with a contradicting transaction in the options market. Secondly, options trading is not different, in principle, than trading the spot market. Spot traders trade the market directly by selling or buying currencies, and options and futures traders do the same, only through contracts, and differing maturities. In short, the options market is a somewhat of a mirror image of the spot market, although the image is a bit distorted, so it is clearly not a perfect substitute.

With all these in mind, let’s remember that one of the most important deficiencies of the forex market: there’s no central exchange, no volume statistics released, and consequently no way of measuring or determining the momentum of the market with this kind of data as we are prone to doing while trading stocks. Options data is relevant and useful in overcoming this problem associated with trading forex. The put/call ratio, the subject of our article is one of the common ways of measuring the exposure of the market to the buy or sell side, and can be used to determine where the market consensus has reached an extreme value, signifying a future reversal.

Let’s suppose that the ratio of buys to sells in the market is 1. This would mean that there’s an equal amount of open contracts in the market, and that the market’s exposure to both sides is roughly equal, i.e., there’s no risk of a violent or sudden reversal, and the ongoing momentum of the market can be sustained on a long term basis. But what is the ratio were 2, for example, if the number of open sell-side contracts was twice that of the longs. To interpret this situation we need a look at past peaks and troughs in the put/call ratio. If in the past such a number was associated with a reversal, we expect that the market is in danger of overextending itself, and that the prices may soon revert to their long term average. This is by not means a certainty however, and the usual cautions about the application of money management strategies with diligence applies here as well, as in all other cases.

Forex is a great and exciting discipline that can improve your understanding of the world of finance, and help you make better financial decisions overall as you extend and diversify your trading career into new and more profitable areas. The put/call ratio and its benefits was our subject in this brief article, but you can find many more tools devised for a better understanding of the markets as you learn forex trading. The key to using them profitably is not just understanding them, but also knowing that they only speak about risks and possibilities, and do not propose any outcome over another with any degree of certainty.

This article is kindly provided by an editor of forextraders.com

This entry was posted on Wednesday, November 11th, 2009 at 2:57 pm and is filed under Trade Methods. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.