Lately, the market has been fairly volatile and many investors are struggling to find long-term direction in the foreign exchange, or forex, market. The majority of consolidation and volatility is centered on the U.S. dollar. Today's proposed strategy is based on removing the U.S. dollar from the equation and using a broader view of the global economy to set up two spreads that create a synthetic cross (i.e., without the dollar in the base or quote).

The Swiss franc is considered a safe haven currency. Historically, during times of war and political unrest, money moves to the Swiss franc. In addition, the Swiss National Bank is recognized as the single-largest holder of bullion, and is also seen as a stable, safe haven bank. The Swiss franc's strength in price action has been noticeable because it has been the strongest currency over the past year in price percentage movement, compared to major world currencies.

In contrast, the Japanese yen has a history of being part of the carry trade, because banks and institutions sell it at a low rate (between zero and 0.5% over the past five years) and buy higher interest currencies to capitalize on interest rate differential in a leveraged market. Today's trade example is not focused on the interest rate that can be received from the trade, but rather, the shift in supply and demand that causes yen to trade in a bearish trend. The yen has been in a distinct bearish move against major currencies since March 2008. Many investors are speculating on the carry trade's return.

Using Philly Swiss Franc options (XDS) for half of the synthetic trade, notice the trend (see Figure 1). It is very bullish and has been for most of the past seven years. Buying the September 95 put and selling the September 97 put creates a bullish vertical spread or bull put spread near a support level. The bull put spread pays a credit of $102.00 per contract with a $96.00 break-even point, which is $0.33 below the current price. That is to say, excluding commissions and dividend risk, the bull put spread can profit if the XDS moves up, remains flat or even drops up to $0.33 by expiration.

Figure 1--PHLX Swiss Franc (XDS) Rising with Strong Trend Support

The Bullish Credit Vertical Spread (bull put spread):
Buy the September 95 put for $1.11
Sell the September 97 put for $2.13

This provides a credit of $1.02 per option, or $102.00 per contract.

Maximum gain potential in dollars: $1.02 per option, or $102.00 per contract.
Amount at risk: $0.98 per option, or $98 per contract (not including possible dividend risk or commissions).

Maximum gain as a percentage of amount at risk: 104%
Break-even price at expiration: $96.00

The yen is a little different than the franc's set up, which is trading a support bounce in an uptrend. The yen appears to have broken out to the downside of a wedge price pattern. For nontechnicians out there, a wedge breakout often runs the wedge's height in the breakout's direction. To be a little more conservative and use key support and resistance areas within the wedge, a $10.00 move could be expected, which would push the XDN back to one-year lows. Selling the September 94.5 call and buying the September 92 call for a bear call spread pays a credit of $100.00 per contract with a breakeven point at $93.05 (see Figure 2). That is to say, excluding commissions and dividend risk, the bull put spread can profit if the XDN moves down or remains flat by expiration.

Figure 2--PHLX Japanese Yen (XDN) Breaking Out of Wedge Pattern

The Bearish Credit Vertical Spread (bear call spread):
Buy the September 94.5 call for $1.02
Sell the September 92.00 call for $2.07

This gives us a credit of $1.05 per option, or $105.00 per contract.

Maximum gain potential in dollars: $1.05 per option, or $105.00 per contract.
Amount at risk: $1.45 per option, or $145.00 per contract (not including possible dividend risk or commissions).

Maximum gain as a percentage of amount at Risk: 72%
Break-even price at expiration: $93.05

The maximum risk on the XDN bear call spread is greater than the gain, which may seem to be against good money management. It can be argued that it is an equal or lesser risk, because probability and risk-to-reward ratios are often inversely correlated. Spot currency market prices are derived by dividing current exchange rates by each other. Analyzing breakeven points, maximum gain and maximum risk on the XDS and XDN at expiration, then deriving the synthetic value at time of expiration, the break-even point on the spot currency pair (CHF/JPY) would have to be 1.0317 or 25 pips below the current price. Maximum risk occurs when the pair price crosses 1.0056 or 294 pips below the current price. Maximum gain occurs at the 1.0544 spot price, up 200 pips from the current price (see Figure 3). The pair's probability of continuing 200 pips higher is greater than its probability of dropping 294 pips, based on historical price action trends.

Figure 3--CHF/JPY with Rising Trend and Max Gain Max Loss Points

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The security used in this example is used for illustrative purposes only. Investools is not recommending that you buy or sell this security. Past performance shown in examples may not be indicative of future performance.

Trading spot currency contracts can involve high risk and the significant loss of any funds invested. Spot currency contracts are highly leveraged. This means that significant losses can be created quickly and unexpectedly.

Options trading is generally more complex than stock trading and may not be suitable for some investors. Granting options and some other options strategies can result in the loss of more than the original amount invested. Before trading options a person should review the document Characteristics and Risks of Standardized Options, available from your broker or any exchange on which options are traded.