The dollar index is a foreign exchange investment product that follows the direction of the US dollar against a basket of currencies. Investors, who are interested in speculating in the currency markets, can use the dollar index as a benchmark index in a way that is similar to trading the Dow Jones Industrial average if they were investing in stocks. Additionally, corporations who have currency exposure to a wide variety of countries, can use the dollar index to hedge their currency risk. Option strategies on the dollar index require the use of options, which are the right but not the obligation to purchase or sell the dollar index at a specific price on or before a certain date.
The Dollar Index
The dollar index is a basket of currency which includes the EURO, the Yen, the British Pound, The Canadian dollar, the Swiss France and the Swedish Kroner. Fluctuations in the dollar index occur based on market sentiment. The dollar is the most liquid global currency and represents a global benchmark in the foreign exchange environment.
Option strategies on the dollar index are the use of one of more option positions to speculate on the direction of the index. Every option strategy presents a different type of risk to investors which can enhance or reduce risk. For example, when an investor purchases a call option, which is the right to purchase the dollar index at a certain price, the investor limits his risk to the premium paid for the option. If the investor sells a call option, his risk is unlimited because the price of the dollar index can rise and is not bound by any level.
A popular option strategy which protects against downward movements in the dollar index is a protective put strategy. A put is the right but not the obligation to sell the dollar index at a specific price on or before a certain date. This strategy is for investors who already own the dollar index and what to protect against an adverse move by purchasing a put. The most an investor will lose from purchasing a put is the premium paid for the option to the seller.
Naked Option Purchases
When an investor purchases a call option or put option but does not own the underlying security that transaction is known as a naked purchase. Naked option purchases are speculative trades on the direction of the dollar index. If a trader believes that the price of the dollar index will move higher, they can purchase a dollar index call option; alternatively if a trader believes the price of the dollar index will decline, they can purchase a dollar index put option. In each instance the option purchaser will pay the option seller a premium to own the option.
[box type=”bio”]This was a guest post by Marcus Holland, editor of FinancialTrading.com[/box]