The Quest For Efficient Markets: Balancing Risk and Reward
When Good predictions Go Bad
What makes the markets tick? How is information priced into the markets? Is there a way to to predict where the markets are headed? Why canít I just create a spread sheet with X Variables to calculate the expected future values of the markets?
Technology has truly altered so many aspects of our day-to-day lives; itís not surprising that we expect the same convenience from the financial markets.
Unfortunately, itís not that simple. As we have learned from the recent market turmoil, financial models can never fully replicate reality. While these models play an important role in helping understand probabilities in the markets, they still canít predict the future.
Instead, investors should focus on diversifying their portfolio into multiple asset classes to help reduce their exposure to risk. One alternative is the listed options market, which offers a wide range of strategies suitable for any market condition with limited risk.
In order to meet your financial goals in todayís environment, itís imperative to consider all of the different asset classes, including cash, equities, bonds, foreign currencies, natural resources, precious metals and real estate. If you are actively managing your own finances, exchange-traded options are one of the most versatile trading instruments with strategies for forecasting and hedging to minimize your exposure to risk.
Itís just a matter of selecting the most appropriate strategy, based on your specific financial goals and risk tolerance. Options are available in equities, equity indexes, and Exchange Traded Funds (ETFs). A relatively recent introduction by the International Securities Exchange (ISE) offers exchange-traded foreign currency options on six of most popular currency pairs.
The markets price risk each and every trading day. How is this risk priced?
According to the Efficient Market Hypothesis (EMH), prices on traded assets
already reflect all known information. There is much debate on EMH since
it assumes that the financial markets are ìinformationally efficient,î meaning itís impossible to outperform the market by using information that it already knows.
Therefore, EMH theorizes that the only way to beat the markets is through random luck. Regardless of your take on EMH, the financial markets still provide
investors with a wide range of trading opportunities in multiple asset classes.
Foreign exchange is the asset class that determines the relative value of money. The markets are constantly anticipating the release of new information, including
ìnumbersî announcements (i.e., Central Bank interest rate policy meeting
employment, inflation, consumer, and housing reports). Since the financial markets are so unpredictable, investors should never lose sight of what is driving their behavior.
Blindly following certain economic releases is not in your best interest ñ you need to know how to interpret the information. While the economic number is important, so is the marketís expectation for that particular release. These expectations cannot easily be quantified. Even if they were, the ìnew informationî is virtually an unknown. So the market reaction to new information further underscores the uncertainty in market
pricing creating even more potential risks.
This is where ISE FX Options can help investors trade their view or hedge their currency exposure. Because options are so versatile, investors can select from a wide range of trading strategies that balance between the risk and rewards trade off
that is most appropriate for them. Though there are many different op-
tions terminology to learn (i.e., calls, puts, expiration months, strike price
premiums, intrinsic value, extrinsic value and volatility), with practice
these terms become almost second nature.
ISE FX Options allow you to implement your view of the U.S. dollar (USD) against the six major currencies, using the USD as the base currency. Using this convention, if you
are bullish on the USD you simply purchase calls. If you are bearish on the USD, you purchase puts. Simple call and put strategies are the most straightforward option strategies.
There are also spread strategies that allow you to implement bullish, bearish, or even neutral options strategies for the USD. Spread strategies also help to mitigate the risks of time decay and volatility.
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To Be Continued In Part Two: FX Options
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