Understanding the risk and reward of each FX options strategy is very important. But possibly even more important, is ascertaining the probabilities of various FX trading outcomes. Just remember the term unlikely does not mean impossible.

- Steve Meizinger
Director of Education,
International Securities Exchange

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May 8, 2007

TRADE FX OPTIONS!

A Smarter Way to Trade Currencies. Trade your views on the strength or weakness of the U.S. Dollar. With ISE FX Options™ you have exposure to rate movements in the global foreign currency market. ISE FX Options are accessible through all options-enabled brokerage accounts.

* ^EUI (Euro)
* ^BPX (British Pound)
* ^YUK (Japanese Yen)
* ^CDD (Canadian Dollar)
(Use ^ for rates on Yahoo! Finance)

Call Your Broker Today!
www.isefxoptions.com

Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of characteristics and Risks of Standardized Options. Copies of the document may be obtained from your broker or from the International Securities Exchange by calling (212) 943-2400 or by writing the Exchange at 60 Broad Street, New York, NY 10004.

One of the fastest growing market segments available today is foreign currencies, also known as Forex or simply FX. Foreign currencies trade 24 hours a day around the globe. There are many different ways to trade FX; the spot market, futures, futures OTC and now index options. That’s right, if you’ve been interested in trading FX and were turned off by the prospect that you had to open a new account with a futures or FX firm, you will soon be able to hedge or speculate on foreign currency exchange rates in your regular brokerage account. All you need is options approval and if you are reading this column, chances are pretty good you already have that.

On 4/17/07 the International Securities Exchange (ISE) which is one of the largest US options exchanges, began offering FX options and they are probably available to you if you have an options approved brokerage account. The ISE has made this product fairly simple to understand because it is essentially a US dollar, cash settled, European style index option; not unlike other better known index options which you may already be familiar with such as: S&P 500 (SPX) and the 13-week treasury bill interest rate (IRX), both of which trade on the Chicago Board Options Exchange (CBOE).

While options on the IRX, for example, allow you to take a position on the direction of short-term interest rates, ISE FX options are tied to an underlying index which is based on the exchange rate of the US dollar to other well known world currencies. If you have an opinion about the strength or direction of the US dollar relative to these other currencies you can use these options to take a bullish or bearish position without ever having to actually hold the foreign currency itself. Since currency sizes vary, ISE decided to move the decimal point on some of the indexes so each currency pair index is expressed at a level that is similar to a stock price. For example, if one US dollar equates to .7577 Euros, the decimal point is moved 2 places to the right and the US Dollar to Euro index level would be 75.77. This type of modification allows for standard option strike prices of 65, 70, 75, 80, 85 etc. A similar “rate modifier” will be used for the US Dollar to British Pound, and Canadian Dollar. However, since the Japanese Yen is a smaller currency unit, the decimal point does not need to be moved. As additional currency pairs are added, the decimal may be moved one or two places to the right to keep them all in the same general price range.

At initial launch, ISE is listing options on the following 4 currency pairs:

If you cannot view the above table, go here.

If FX is not something you’ve considered before, I’d like to introduce you to some of the reasons why you may want to take another look. Consider that a weak dollar is beneficial to American companies that produce goods domestically and export them abroad. This is true because these companies will typically be paid in the currency where the goods are sold and then when that currency is converted into US dollars; it will buy more dollars the stronger that currency is relative to the US dollar. Since these are US companies, their earnings will be reported in US dollars and this will boost earnings. When the dollar is relatively weak as it is at the present time, as shown in the chart below, many US companies will benefit from increased sales overseas. Of course if this is true, a strong dollar has exactly the opposite affect. Not only will the foreign currency buy fewer US dollars, it is also more difficult to sell domestically produced goods abroad because those goods are effectively more expensive and therefore less attractive to international consumers.

If you cannot view the US Dollar to Euro Exchange Rate – 5 Years chart, go here.

By contrast a strong dollar is beneficial to companies that import foreign goods into the US. This is true because whether these companies typically buy foreign goods in US dollars or convert US dollars into the foreign currency, a strong US dollar converts to a larger amount of the foreign currency, effectively allowing the US company to pay less for the foreign goods. Of course a weak US dollar hurts this type of company because a weaker dollar buys less foreign currency therefore raising the price of imported goods. In this environment domestically produced goods will become more competitively priced against imports, to domestic consumers. As an example, American automobile manufacturers that sell most of their cars in the US may benefit from a weaker dollar as domestically produced cars would become relatively cheaper compared to imports.

Despite the fact that the US typically runs a sizable trade deficit with most international trading partners, US government policy is typically in support of a strong US dollar. When domestic interest rates are at a level that is lower than other major foreign currencies, such as back in mid-2003, the dollar usually loses strength as international investors sell US dollars to invest in foreign markets where higher returns can be earned. As domestic interest rates rise, as we’ve seen in the past 3 years, investing in US dollars becomes more attractive and this typically causes a strengthening of the dollar despite the fact that the trade deficit may widen. For this reason, you might expect to see a close correlation between interest rates and the strength of the dollar, but this doesn’t always happen due to other factors such as economic growth and inflation. As an investor you probably already know that the rise in interest rates which began in mid-2004 also contributed to a turnaround in the stock markets as shown by the S&P 500 ($SPX) in the chart below.

If you cannot view the S&P 500 ($SPX) chart, go here.

Geopolitical and international monetary policies of the subject countries also affect these exchange rates. If you have an opinion about the economies in Europe, Canada or Japan, or where their interest rates are headed, you now have an easy way to hedge or speculate in that regard. Major national and international manufacturing companies have hedged against these types of currency fluctuation risks for years, but up until now, as a retail investor you would have had to open a separate account with an FX trading firm or a futures broker. With this new ISE product, you can now do it with minimal effort.

For example, if you believe the US Dollar will gain ground versus the Euro, you may want to establish a bullish position using options of the $EUI index. Appropriate bullish strategies might include long calls, short puts, debit call spreads or credit put spreads. If you believe the US Dollar will hold steady versus the Japanese Yen you may want to establish strategies on the $YUK index that gain value through time decay when there is little movement in the underlying. Appropriate strategies might include long butterflies, long condors, long iron butterflies or long iron condors. If you believe the US Dollar will lose ground versus the Canadian Dollar you may want to establish bearish strategies on the $CDD index. Appropriate bearish strategies might include short calls, long puts, credit call spreads and debit put spreads.

The official level of each of these exchange rate indexes will be calculated by Reuters about every 15 seconds throughout the trading day and as I mentioned previously, these options will trade pretty much the same as any other European style index options with only these few minor differences:

• On expiration Friday trading will end at 12:00 PM Eastern time
• Regulations allow for higher leverage than regular index options but because house requirements can vary, be sure to check with you broker to determine how the margin will be calculated.

If you are already approved for options trading you will soon receive an addendum to the OCC Options Disclosure Document titled “Characteristics and Risks of Standardized Options” which specifically pertains to this product and a similar product available on the Philadelphia Options Exchange (PHLX). Clearly there are a lot of factors that play into the foreign exchange rates but as the old saying goes “the only thing constant is change”. This is certainly true of foreign exchange rates and where there is change there is also risk and opportunity.

Randy Frederick is Director of Derivatives for Charles Schwab & Co., Inc. He is the chief architect of Schwab’s option trading platforms and analytics tools. Frederick also author’s monthly columns for Schwab’s client newsletters, and is the host of the weekly radio show “The OPTIONal Hour” on TFNN. His articles have been published in trade magazines such as Active Trader, SFO, and Futures. A respected industry veteran, he is a frequent guest on CNBC, and his comments appear regularly in the financial news media including The Wall Street Journal, Barron’s, Financial Times, Bloomberg, Dow Jones, Reuters, USA Today and TheStreet.com. Mr. Frederick is the Electronic Access Member (EAM) representative on the board of the International Securities Exchange, LLC.

TRADE FX OPTIONS!

A Smarter Way to Trade Currencies. Trade your views on the strength or weakness of the U.S. Dollar. With ISE FX Options™ you have exposure to rate movements in the global foreign currency market. ISE FX Options are accessible through all options-enabled brokerage accounts.

* ^EUI (Euro)
* ^BPX (British Pound)
* ^YUK (Japanese Yen)
* ^CDD (Canadian Dollar)
(Use ^ for rates on Yahoo! Finance)

Call Your Broker Today!
www.isefxoptions.com

Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of characteristics and Risks of Standardized Options. Copies of the document may be obtained from your broker or from the International Securities Exchange by calling (212) 943-2400 or by writing the Exchange at 60 Broad Street, New York, NY 10004.