Like other major financial markets The forex market has a variety of active derivative markets that utilize forex currency pairs as the base asset.
Derivatives are evaluated using an pricing model derived from various market-derived parameters. In the market for foreign exchange one of the biggest and most enduring of these classes of derivatives are called FX, forex and currency option. Options traded on markets like the Over the Counter or OTC market, and on specific stock and futures exchanges. Options trading in FX is increasing accessible to traders who are retail through trading websites.
The market for currency options comes with its own over the counter brokers, which are different from traditional forex market brokers. It is worth noting that the FX Options market produces a huge daily turnover, making it among the most liquid derivative markets around the globe.
What is Currency Options?
In general the case of currency options, they are financial contracts that grant the right, but not the obligation to the buyer to exchange a certain amount of one currency to another at a specific exchange rate, also known by the term strike. The purchaser of a currency option must pay the seller a fee or premium in order to get this right.
If the buyer of an option wants to exercise their option to purchase currency, they must exercise it prior to the end of the contract’s existence. This is also called the expiration date.
When exercising the declared change of currency at strike prices will then occur on the date of settlement specified in the contract typically the date of delivery on the day that the option’s exercise is completed. For futures contracts involving currency the date of settlement is the date of the contract that is underlying.
Options with an exchange rate that is higher than the exchange rate that is in effect for the specific delivery date are referred to as In the Money. Options with a strike rate that is the same as the current spot exchange rate are referred to as being at the Money Spot and those with a strike rate that is set at the current forward rate are considered to be at the money Forward. FX options that are struck at an exchange rate that is lower than the current forward rate are referred to as out of the money.
Because FX options are essentially alternatives to an exchange rate and are not a vanilla or regular currency, options typically involve the purchase of one currency, and the selling of a different currency. The currency that is purchased if the option is exercised is called the call currency, whereas the currency that is sold is referred to as”put currency.
Additionally, currency option contracts usually specify a specific type of exercise. The style that is specified can vary, but it could be American Style, which implies that the option may be used at any time prior to the expiration date, as well as European Style, which signifies that the option will only be exercised upon its expiration date within a specific date.
Applications for Currency Options
Options on currency can be purchased as an insurance policy that can be used to safeguard or hedge an anticipated or existing forex position. In this scenario the premium for the option is paid to guarantee the the execution of that forex trade at the strike price of the option.
Additionally the currency options may be traded against an existing forex position to generate an additional source of income, which can increase the breakeven rate of the position. It is similar to the strategy of covered writing employed by some stockholders. For instance an investor who is in the long-term GBP/USD currency pair could decide to sell an out of money GBP Call/USD Put in order to keep their profit to the amount of the strike price , while increasing their breakeven in the event that the market declines.
Options trading in forex can be combined with options into various strategies that are able to make strategic decisions in the market for forex based on an underlying market outlook and to hedge against potential negative movements, and to boost yield.
The currency options are also utilized to place bets on the amount of movement expected in the market for forex. Since an indicator called implied volatility is used to determine the price of options in the currency market that reflect the magnitude of changes expected in the market, their value is likely to rise and decrease based on the magnitude of the market-determined quantity. This permits professional forex traders to have their own opinions on the implied volatility of trades.
How are European Currency Options priced
Alongside having their price set by demand and supply on exchanges such as those on the Chicago IMM and PHLX exchanges Currency options are theoretically priced by using an altered mathematical pricing model that is based on the classic Black Scholes option pricing model which was developed to determine the price of stock options.
This model of pricing for currencies is referred to by Garman Kohlhagen model. Garman Kohlhagen model, after two researchers who were named Garman as well as Kohlhagen changed their Black Scholes model in 1983 to account for the interest rates that are applicable to both currencies in a pair.
The Garman Kohlhagen price for currency options typically require input of the following parameters in order to create a hypothetical price for the European Style currency option:
call currency : The money of the currency pair to which gives an option to buy to the buyer.
Put the currency of the currency pair to which gives an option to purchase to the purchaser.
Strike Price – The price at the rate at which the two currencies of the currency pair that is the base will be exchanged when the option is granted.
Expiration Date – The sole date on which this option is available because it’s an European Style option.
Spot Rate – The current exchange rate for the base currency pair.
Spot Delivery Date – The day when the currency will be exchanged , if the option is granted.
Forward Rate – The current forward exchange rate of the currency pair that is used for the option’s settlement or delivery date.
Option Delivery Date or Settlement Date the date when the currencies that are underlying will be exchanged in the event that the option is granted.
Implied Volatility – This is the market-determined level of implied volatility of the underlying currency pair as well as for the specific tenor of the option.
Inputting the above data into a computer program that is coded using an algorithm based on the Garman Kohlhagen price model, you will get an amount that is usually presented in terms of a percentage of the base currency amount on the market for over-the-counter products. For exchanges such as Chicago IMM Chicago IMM, the quoted price could be expressed in U.S. points per currency amount, meaning that the price for the option is likely to pay in U.S. Dollars.
To complete an exchange, the amount of one currency has be provided by the marketplace maker. This will enable the proper calculation of the premium which is the amount stated in one of the options currencies , which the buyer will have to provide to the seller in order to buy this exchange-traded currency contract.
Option Intrinsic Value and Extrinsic Value
European as well as American Style currency options have two elements that contribute to their value.
The first portion is referred to as intrinsic value and it is the positive variation, if any, between the strike price of the option and the current forward exchange rate at the date of delivery. Options that are in value, have lower implied volatility, and near expiration, tend to have prices that are made mostly by intrinsic worth.
The second portion of an option’s cost is called extrinsic value which is the remainder of the market value of the option. Options with a significant implied volatility with a long duration remaining before expiration, and strike prices that are located at the price of money are likely to have the greatest extrinsic value. The time component of the extrinsic value is commonly referred to as the time value.
American Style options on the more expensive currency typically have a slightly greater time value than the essentially identical European Style options, as the next section will discuss more in depth.
American Style Currency Option Pricing and Early Exercise Criteria
American styles of options can exercisable at any point before expiration, therefore their pricing is subject to a change to the pricing model which is incorporated into the known as the Binomial Model typically used to price these types of options.
The factors used to price American Style currency options are identical to those mentioned in the above table in the case of European Style currency options, however, the pricing of these options must be able to take into consideration the small benefit of exercising earlier to the purchaser. In reality, this implies the American Style forex options are typically comparable in cost to but not necessarily cheaper as European Style options.
The distinction between the typically more expensive price for the American Style option when compared to that of an European Style option with otherwise similar parameters is often referred to as the Ameriplus in the world of currency option traders.
The early exercising of an American Style option will eliminate any time value that remains in the option, which could be significant in the value of the option — these options are typically only executed early if they’re high in money call option on the currency with a higher interest rate.
In addition, in order to justify an early exercise in this case, to justify early exercise, the American Style option needs to be worth the investment in a way that the positive carry over the base position up to the date of delivery is greater than the option’s actual time value. If this isn’t the case, it’s generally more beneficial to sell these American Style options to capture the time as well as the intrinsic value, instead of having to exercise them prematurely and forfeit all remaining value of the time in the process.
It is the OTC FX Options Market
It is the Over the Counter market for options in currency is a common feature of the largest financial institutions as well as their customers. Forex options trading typically is conducted over the phone or through electronic systems for dealing between the clients from the institution as well as the deal desk and market makers at the institution. Clients of the dealing desk could be seeking to hedge corporate exposures , if they are representing an interest in the corporate sector or may be seeking to take speculation-based positions in a currency pair by using forex options, if they are employed by an investment firm, for instance.
Additionally, specialist forex option brokers can provide implied volatility levels and the delta level, or strike of interest in currency options which reflect the degree of liquidity for the choice. This permits currency options market makers to offer accurate quotations.
When the implied volatility as well as the delta level, or strike price of an transaction has been agreed upon by the broker and the OTC Forex option broker can connect the seller and buyer together, if credit lines are in place between the possible counterparties to accommodate the magnitude that the deal.
In general professional market makers who operate within OTC FX market OTC FX market will typically require that clients who come through their deal desks have an interest in option that is greater than $1,000,000 in the notional amount, whereas the OTC FX options broker would generally only assist with options with notional values greater than $5 million.
Other ways to trade Currency Options
If you are not eligible for or would prefer not to trade on OTC, or do not want to trade in the OTC market, gaining knowledge of the ways to trade currency options through other channels could require some investigation.
If you prefer the transparency of pricing when transacting derivatives through an exchange, a number of major exchanges offer liquidity in small amounts of dealing for traders to conduct currency option transactions.
For starters forex options are traded on exchanges for futures such as those of the Chicago International Monetary Market or IMM. These are contracts for currency that are based on futures which means that the asset isn’t an OTC spot trade like OTC markets. OTC market. It is rather it is a futures contract. They typically have standard calendars for delivery on a quarterly basis like the months of March, June, September , and December.
Additionally, some stock exchanges also provide options for currency. One of the most popular examples is the Philadelphia Stock Exchange or PHLX which offers standard forex option contracts that have monthly delivery dates, which deliver to the spot market, not futures contracts.
A fairly recent option for trading that has widened the currency option access to the retail market is the introduction of forex option brokers online. They typically offer markets that are conventional European and American type options similar to those found in OTC currency market, or offer exotic options in the form of binary options to clients who want to speculate on the movements of currency pairs.
