The market channels frequently. This is tough on active traders as channels can be very difficult to trade.

Sometimes these channels coincide with very important and widely anticipated news events. The passage of the stimulus and the bank bailouts are great examples of this kind of situation. Traders are faced with a tight market that may or may not break out of its channel.

In these situations, it might be easier to trade where the market won’t go rather than where you think it will go.

Option sellers essentially trade this way all the time. Selling options is a great way to take a non-directional trade and turn the disadvantages of buying options into advantages.

Selling or writing an option means that you are opening an option trade by selling the option short. When you enter this trade, you are paid the option cost, or premium, up front.

There are a few significant factors to consider as you evaluate and enter this trade. We will walk through each of these issues in a case study.

Selling the Option

Selling out-of-the-money options is a great way to start using this strategy. Although it is perfectly acceptable to sell in-the-money options, new options traders will usually start the other way around because it seems a little more conservative.

Selling an option means that there are two market conditions that will result in a profit. First, the market could stay flat, which will result in you keeping the premium of the option you sold. Second, the market may trend the direction of your forecast and you will still get the maximum profit.

Our case study will be on the GBP/USD during the decline in January-February 2008. The market had retraced to resistance on 1/30 (point A.)

Forex traders would normally evaluate a short spot trade to take advantage of a move to the downside, but writing an option may be more attractive and provide a little more room for a volatile market. In this case, assume that a call was sold with a strike price 130 pips above the close price on 1/30 at 2.0000.

It may sound a little unexpected to sell a call if you are bearish, but remember that now you are an options seller, not an options buyer, so things are reversed. You want the market to fall so that the call you sold will fall in value or expire worthless. If you were bullish and wanted to sell an option, you would sell a put because you want the market to rise and that put to fall in value.

In the case study, assume that you sold a call with about 2 and a half weeks until expiration on Feb. 15, 2008, and that call is worth $145 for a $10,000 lot. That is the equivalent of 145 pips.

What you want in this trade is for the exchange rate to stay below your strike price until expiration. In the image you can see two dotted line barriers that outline where you want prices to stay and within what time frame.

Let’s review the features of this trade:

1. You are opening the position by selling an option

You are the seller of the option, which means that you are being paid the premium when you open the trade. You will lose money if the market rises above your strike price,but will keep the entire premium if the market closes at expiration on or anywhere below the strike price.

2. Breakeven is equal to the strike price plus premium paid

The premium you are paid can offset some losses if the market rises near expiration. Your breakeven point at expiration is actually 145 pips above the strike price you sold (2.0145) because that is equal to the premium you were paid.

3. Time value works in your favor

This is an out-of-the-money option with no intrinsic value. The entire premium is made up of time value, which melts or reduces the closer you get to expiration and the more the market trends down.

4. Exiting the trade

You can exit this trade whenever you need to. If the market has fallen and the value of the call has declined to a desirable level, you can exit the trade by buying the call back for a cheaper price. You are then free to decide whether you want to sell another call for a larger premium. Alternatively, you can let the call expire when it has no value and keep the entire premium.

5. Margin

Selling a call means you have an obligation to cover losses that may occur if the trade moves against you. For example, if the market begins to rise, the call will gain in value and could become worth more than you sold it for. Most brokers or options dealers will require you to cover this trade with a margin requirement.

As a general rule of thumb, you are usually going to have to cover an options position with 20% of the notional value when trading exchange options, which is a leverage ratio of 5:1. Options offered by forex dealers usually have a much higher leverage ratio closer to spot leverage rates. If you are a very aggressive trader, working with an options dealer rather than a broker may be the best way to go.

Why do forex traders care if equities are in a bull market? Find out here.

John Jagerson is a contributor to LearningMarkets.com. To learn more about him, read his bio here.