Bear Currency Spreads

Traders looking to minimise costs and risks associated with taking currency positions have a variety of alternatives available with options instruments. They may be looking to avoid setting stops for their positions, which could lock them out of gains if the market price moves back into a range they find profitable after the stop. The importance of finding hedging strategies is also underscored by the high leverage available that, while multiplying the profits on a winning trade, can also multiply the potential for loss if a trade does not go as expected.

A variety of strategies such as "straddles," "strangles," "butterflies" and "condors" have evolved to help traders hedge against loss and take advantage of price movements, but the options market itself can present risks related to premiums paid as transaction costs. One strategy some traders may use to minimise this risk is bear currency spreads.^[1]

What Is A Bear Currency Spread?

A bear currency spread—like its counterpart, a bull currency spread—involves buying an option (the long leg) for a particular currency and selling an option (the short leg) for the same currency and expiration at a different exercise price.

The bear currency spread can be carried out in one of two ways, using either call options or put options. With call options, the bear spread strategy is carried out by buying a call option (the long leg) for a particular currency and selling a call option (the short leg) for the same currency and expiration at a lower exercise price. Similarly, with put options, the spread strategy is carried out by buying a put option for a currency at a higher exercise price and selling a put option for the same currency and expiration at a lower exercise price.

Betting On A Downward Move

The bear currency spread is commonly used when traders expect that a currency will depreciate moderately, but not by much. With the bear currency spread, a trader opts to limit the potential for profit in exchange for reducing the cost of taking a position. If the currency depreciates to the full value of the lower exercise price, the trader can take the maximum gain.

By establishing an upper and a lower limit, the trader faces an "opportunity cost" of not taking still larger gains that could be made with a "naked" option. But because premiums paid on options transactions are higher when closer to the spot price, the execution of a bear call spread will earn a net premium while a bear put spread will be charged a net premium. In either case, the premiums of the long and short legs of the bear spread will at least partially offset one another, thus reducing the cost of taking the position in a currency.^[2]

As an example of a possible trade, a trader may consider establishing a bear call spread in New Zealand dollars at exercise, or "strike," prices of US$.85 and US$.84, with premiums of US$.018 and US$.014, respectively. If the New Zealand dollar moves downward to US$.843 before or at the expiration, the trader can exercise the contracts to post a small gain. The result will be US$.84 (lower call strike price) - US$.843 (higher call price) - US$.014 (premium paid for buying lower-priced call) + US$.018 (premium received for selling higher-priced call) for a net gain of US$.001 per currency unit. For a contract with a lot size of 100,000 units, the trade would be worth US$.001 x 100,000 = US$100.

If the currency moved to US$.80, the gain [DR1] would be US$.80 (lower call price) - US$.85 (higher call price) - US$.014 (premium paid for buying higher-priced call) + US$.85 (proceeds from higher call) - US$.80 (cost of lower call) + US$.018 (premium received for selling lower-priced call) for a net of US$.004 per currency unit. For a contract with a lot size of 100,000 units, the trade would be worth US$.004 x 100,000 = US$400. While this trade makes a greater profit, the gain is limited to US$.004 for any future spot price below US$.84.

In the other direction, however, the position may still yield a loss. If the New Zealand dollar moves to US$.845, the result would be US$.84 (lower call strike price) - US$.845 (higher exercise price) - US$.014 (premium paid for buying lower-priced call) + US$.018 (premium received for selling higher-priced call) for a net loss of US$.001 per currency unit. For a contract with a lot size of 100,000 units, the trade would cost US$.001 x 100,000 = US$100.^[3]

In the U.S., currency options contracts are commonly traded at the Philadelphia currency exchange, the Chicago Mercantile Exchange and at online exchanges. In Europe, they can be traded on the Eurex Exchange. Some exchanges offer "one-leg contracts" and same-day expirations to simplify the process of making trade orders.

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