Similar to other important financial markets The forex market has a variety of active derivative markets that utilize forex currency pairs as their underlying asset.
Derivatives are valued based on the price model of the market’s parameters. In the market for foreign exchange is perhaps the largest and most well-established of these classes of derivatives is known as FX, forex also known as currency or forex options. They are traded in markets like the Over the Counter or OTC market, and on certain futures and stock exchanges. FX options trading is even getting more accessible to retail traders via trading sites online.
The market for currency options has its own over counter brokers that are distinct from typical forex brokers. It is worth noting that the FX Options market produces a significant daily turnover, which makes it among the most liquid derivatives markets around the globe.
What are Currency Options?
In general these are financial agreements that give the right but not the obligation to the buyer to exchange a certain amount of one currency against another at a specific exchange rate referred to in the form of the strike. The purchaser of a currency option must pay the seller a cost or premium in order to get this right.
If the buyer of the option wishes to exercise their currency option, they have to exercise it prior to the end of the contract’s existence. This is also known as the option’s expiration date.
At the time of exercise the change of currency at the strike price is then to take place on the contract’s specified settlement date that is typically the day of delivery at the date when the option’s exercising. For futures contracts involving currency the settlement date will be that of the contract that is underlying.
Options with an expiration date that is greater than the prevailing exchange rate for the specific delivery date are referred to as In the Money. Options with a strike rate identical to the current spot exchange rate is said To be at the money Spot, while those with a price set at the prevailing forward rate are considered to be at the money Forward. FX options with an exchange rate lower than the forward rate in force are referred to as Out of the Money.
Because FX options are essentially options on an exchange rate which is a regular or vanilla currency options usually involve the purchasing of one currency and selling of another. The currency that can be purchased if the option is granted is known as the call currency, whereas the currency that is sold is known as”put currency..
In addition, currency option contracts usually have a specified design for exercising the option. The stated style could vary, but it could be American Style, which implies that the option could exercise at any time prior to its expiration date, or European Style, which signifies that the option may only be exercised upon its expiration date, and by a specified time.
Utilization of Currency Options
Currency options can be purchased in order to use them as an insurance policy in order to protect or hedge an anticipated or existing forex position. In this scenario the premium of the option is paid to ensure an execution of the forex position at the strike price for the option.
Additionally to this, currency options can be purchased against an existing forex position to generate additional income and increase the breakeven of the position. This is similar to the strategy of covered writing that is employed by some stock owners. For example traders who are long the GBP/USD currency pair may decide to trade an out of pocket GBP Call/USD Put to limit their profit to the amount of the strike price while improving their breakeven point if the market was to fall.
Option trading on forex can be combined with options to create a range of strategies that are able to take strategic positions on the forex market , based on a specific market view as well as to hedge positions against any potential adverse changes and to enhance yield.
They can also be utilized to place bets on the magnitude of the movement expected in the market for forex. Since an indicator called implied volatility is utilized to price options on currency, which reflects the level of fluctuation that can be expected in the market the value of these options tends to increase and decrease based on the amount of the market-determined quantity. This allows professional forex traders to take views on the implied volatility of trades.
How European Currency Options are Priced
In addition to having their price set by demand and supply on exchanges such as PHLX and the Chicago IMM and PHLX exchanges, currency options can be theoretically priced by using an altered mathematical pricing model that is based on the standard Black Scholes option pricing model which was developed to determine the price of stock options.
This model of pricing for currencies is referred to in the Garman Kohlhagen model because researchers identified as Garman and Kohlhagen modified the Black Scholes model in 1983 to include the interest rates that are applicable to both currencies used in a pair.
Traders who use the Garman Kohlhagen model of pricing for currency options generally need to input one or more of the following parameters in order to determine a potential price for a European Style currency option:
Contact Currency: This is the currency that is in the currency pair to which allows rights to purchase the buyer.
Put Currency – The currency that is in the currency pair that is the choice that grants an option to purchase to the purchaser.
Strike Price – The rate at the rate at which the two currencies of the currency pair in which they will be exchanged in the event that the option is exercised.
Expiration Date – The sole day on which this option is available because it’s a European Style option.
Spot Rate – The current exchange rate of the currency pair.
Spot Delivery Date: The date when the currency will be exchanged if the option is exercised.
Forward Rate – The prevalent forward exchange rate for the currency pair that is used for the option’s delivery or settlement date.
Option Delivery Date or Settlement Date the date when the underlying currencies will be exchanged when the option is granted.
Implied Volatility: The implied volatility for the underlying currency pair and the determined tenor for the option.
Inputting the above data into a computer program that is coded with this Garman Kohlhagen price model will result in an amount that is usually described in real life as a percentage of the base currency amount on the marketplace for over the counter. On exchanges like that of the Chicago IMM, the quoted price might be expressed in U.S. points per currency amount. The premium for the option will typically be paid in U.S. Dollars.
To be able to carry out the transaction, the value of a currency needs to be specified for the trader. This will ensure the correct computation of the premium, which is the amount expressed in either of the option’s currencies that the buyer would have to pay to the seller in order to purchase this currency option contract.
Option Intrinsic Value and Extrinsic Value
European and American Style currency options have two elements that contribute to their value.
The first component is referred to as intrinsic value, and it is the difference, if any, between the option’s strike value and the prevailing forward exchange rate as of the date of delivery. Options that are deeply in the market, with very low levels of implied volatility, and are close to expiration tend to have prices made entirely from intrinsic values.
The second element of the price of an option is also known as extrinsic price, and comprises the remainder of the option’s current market price. Options that have a higher implied volatility and a long duration remaining before expiration, and strike prices situated at the money tend to have the highest extrinsic value. The intrinsic value of time is often referred to as the value of time.
American Style options on the higher interest rate currency have a slightly greater time value than those that are otherwise the same European Style options, as the following section will explain more in depth.
American Style Currency Option Pricing and Early Exercise Criteria
American style options are able to be exercised at any point prior to expiration, which means their pricing requires a modification to the pricing system that is incorporated into the known as the Binomial Model typically used to price this style of option.
The factors used to price American Style currency options are similar to the inputs listed previously for European Style currency options, however the pricing of these options should consider the possibility of a modest advantage of exercising early to the purchaser. In real life, this means the American Style forex options are generally the same price but they aren’t any more expensive than European Style options.
The distinction between the typically more expensive price that is associated with the American Style option when compared to that of that of European Style option with otherwise identical parameters is sometimes referred to as the Ameriplus for currency option traders.
The early exercise of an American Style option will eliminate the remaining time value in the option — which could be quite a significant portion of its value , such options are typically only activated earlier if they’re very high in the money call option on the currency with the highest interest rates.
To justify the earlier exercise to justify early exercise, the American Style option needs to be in the market in the sense that the positive carry on the principal position up to the date of delivery currently exceeds the option’s presently present value in time. If this isn’t the case, it is normally more beneficial to sell back such American Style options to capture the time as well as the intrinsic value rather than exercise them prematurely and lose all of the remaining value of the time due to.
The OTC FX Options Market
It is the Over the Counter market for forex options is operated by large financial institutions and their clients. Trading in forex options generally takes place over the telephone or through electronic systems for dealing between customers at the bank as well as the market desk and dealing desk makers at an institution of finance. Clients of the dealing desk could be seeking to hedge corporate exposures , if they are representing an interest in the corporate sector or might be looking to take speculative positions in a currency pair using forex options, if they are part of an hedge fund, as an example.
Furthermore, specially trained forex option brokers will quote levels of implied volatility and the delta level or strike of interest in currency options that are indicative of their financial sturdiness for the option. This allows market makers to offer efficient quotations.
When the implied volatility, the delta level, or strike price of the transaction is agreed upon with the broker and the OTC forex option broker can join the seller and buyer together if there are enough credit lines exist between the possible counterparties to accommodate the magnitude that the deal.
In general professional market makers who operate within the OTC FX market will typically require that clients who come through their desk have an interest in option that is greater than $1,000,000 in its notional amount, while OTC FX options brokers will typically only assist with transactions that exceed $5,000,000. OTC FX options broker would typically be able to assist with option transactions that have notional amounts higher than $5,000,000.
Alternatives to Trading Currency Options
If you do not qualify for, or do not want to trade in OTC, or do not want to trade in the OTC market, learning about trading currency options through other channels could require some investigation.
If you prefer the more transparent pricing of trading derivatives on an exchange, the majority of exchanges provide liquidity in reasonable amounts to traders to execute currency option transactions.
To begin with forex options are traded on futures exchanges like the Chicago International Monetary Market or IMM. These options for forex are essentially contracts for currency that are based on futures as such, meaning that the actual asset isn’t the same as a spot transaction in market. It is not an OTC marketplace, however it is typically it is a futures contract. They typically have standard date of delivery for the quarter like March, June, September , and December.
Additionally, some stock exchanges also provide options for currency. One example is Philadelphia Stock Exchange or PHLX that provides Forex option contracts that are standardized and have regular delivery dates. They are delivered into spot, rather than futures contracts.
A fairly recent option for trading that has widened the currency option availability to the retail market has been the development of online forex option brokers. They usually offer markets that are the traditional European and American styles, similar to those found in OTC currency option market, or they provide exotic currency options such as binary options to clients seeking to speculate on the movements of currency pairs.
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