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What Are FX options?

Similar to other important financial markets Forex market offers a number of active derivatives markets that utilize forex currency pairs as an underpinning asset.

Derivatives can be valued by the price model of the market’s parameters. The market for foreign exchange Perhaps the largest and longest-running of these derivative classes are variously known as FX, forex or currency options. They are traded in market called the Over the Counter or OTC market, as well as on certain futures and stock exchanges. Options trading in FX is more often accessible to traders at retail via online trading outlets.

The market for currency options comes with its own over the counter brokers that differ from typical forex brokers. This FX Options market produces a huge daily turnover, making it among the most liquid derivative markets anywhere in the world.

What is Currency Options?

In general these are financial contracts which grant the right, but not the obligation for the buyer to exchange a certain amount of a currency for another at a specific exchange rate referred to as the strike price. The person who purchases a forex option pays the seller a cost or premium to gain this right.

If the option buyer wants to exercise their currency option, they have to make the exercise on or before the end of the contract’s existence. It is also known as the option’s expiration date.

In the event of exercising, the stated exchange of currencies at strike prices will then occur on the contract’s specified settlement date which is typically the spot delivery date on the day that the option’s exercise is completed. In the case of currency futures options contracts the date of settlement will be the one of the underlying futures contract.

Options with the strike price higher than the exchange rate that is in effect for the date of delivery are said to be In the Money. Options with a strike rate that is the same as the current spot exchange rate are said as being at the Money Spot and those with a price fixed at the current forward rate are considered to be in the Money Forward. FX options with an exchange rate worse than the prevailing forward rate are known as out of the money.

Since FX options are choices on exchange rates which is a regular or vanilla currency options typically require the buying of one currency and the selling of another. The currency that is purchased when the option is exercised is known as the call currency. While the currency that can be traded is known as”put currency..

Additionally, currency option contracts typically specify a design for exercising the option. The style that is specified can vary, but it could be American Style, which implies that the option can be used at any date prior to the expiration date as well as European Style, which signifies that the option may only be exercised upon its expiration date by a certain date.

Utilization of Currency Options

Option to purchase currency is a way to be used like an insurance policy to protect or hedge an anticipated or existing forex position. In this instance the premium for the option is paid in order to ensure the successful the execution of that forex trade at the option’s strike price.

In addition the currency options may be purchased against an existing foreign currency position to earn additional income that increases the position’s breakeven rate. This is similar to the strategy of covered write used by some stock holders. For example traders who are trading the currency pair GBP/USD could sell an out of the money GBP Call/USD Put, which limits their profit to the amount of the strike price , while increasing their breakevens if the market were to decline.

The trading of options in Forex can be used to integrate options in a variety of strategies. These strategies can be utilized to take strategic positions in the forex market based on an underlying market outlook as well as to hedge positions against possible adverse movements and to boost yield.

The currency options are also employed to bet on the magnitude of the movement anticipated in the underlying market for forex. Since a parameter called implied volatility is used to determine the price of options for currency that reflect the magnitude of changes that are anticipated in the market their value is likely to rise and fall based on the degree of this market determined quantity. This allows professional forex traders to make their opinions known the implied volatility of trades.

How are European Currency Options priced

Alongside having their prices determined by supply and demand in exchanges like that of the Chicago IMM and PHLX exchanges Currency options are theoretically priced with an improved mathematical pricing model based upon the classic Black Scholes option pricing model that was created to price stock options.

This model of pricing for currencies is referred to as Garman Kohlhagen model. Garman Kohlhagen model following the discovery of researchers named Garman as well as Kohlhagen made changes to the Black Scholes model in 1983 to account for the relative interest rates on both currencies in a pair.

Traders using the Garman Kohlhagen price for currency options generally need to input one or more of these parameters to determine a potential price for a European Style currency option:

Call Currency – The currency used in the currency pair in which the option will grant rights to purchase to the buyer.
Put Currency – The currency that is in the currency pair in which is the choice that grants an option to purchase to the purchaser.
Strike Price – The rate at when the two currencies of the currency pair that is the base will be exchanged if the option is granted.
Expiration Date: The only 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 date at which the currencies will be exchanged if this option is granted.
Forward Rate – The prevalent forward rate of exchange for the currency pair that is used for the option’s delivery or settlement date.
Option Delivery or Settlement Date the date on which the currencies of the option are exchanged if the option is granted.
Implied Volatility – This is the market determines the level of implied volatility that is applicable to the currency pair, as well as the specified tenor of the option.

Entering the above information into a computer-generated program using this Garman Kohlhagen pricing system, you will get the price that is often described in real life as a percentage of base currency amount in the over the counter market. For exchanges such as the Chicago IMM, the quoted price might be expressed in U.S. points per currency amount so that the premium for the option will typically be paid in U.S. Dollars.

To complete a transaction, the amount of one currency will need to be communicated to the market 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 purchase the currency option contract.

Option Intrinsic Value and Extrinsic Value

European and American Style currency options have two factors that determine their worth.

The first is known as intrinsic value, and it is the value of the difference between the option’s strike value and the prevailing forward exchange rate as of the date of delivery. Options that are deeply in the money, with very low levels of implied volatility and near expiration, tend to have their prices made up almost exclusively in intrinsic value.

The second component of an option’s price is called extrinsic value and it comprises all the remaining part of the market value for the option. Options with a high implied volatility, a long time to expire and strike prices situated at the price of money are likely to have the highest extrinsic value. The time component of the extrinsic value is often referred to as the time value.

American Style options on the more expensive currency typically have a slightly higher time value than similar European Style options, as the following section will explain more fully.

American Style Currency Option Pricing and Early Exercise Criteria

American style options can be exercised at any time before expiration, therefore their pricing needs to be adjusted to this pricing model that is now integrated into the so-called Binomial Model typically used to price these types of options.

The factors used to price American Style currency options are identical to those mentioned below for European Style currency options, however, the pricing for these options needs to be able to take into consideration the modest advantage of exercising earlier to the buyer. In reality this means the American Style forex options are generally the same price but are not much more expensive as European Style options.

The difference between the often higher price that is associated with one American Style option when compared to the European Style option with otherwise identical parameters is sometimes known as the Ameriplus among traders of currency options.

The early exercising of an American Style option will eliminate the remaining time value in this option — which can be quite a significant portion of its value — these options are generally only executed early if they’re high in money call option on the currency with the highest interest rates.

Additionally, in order to justify the early exercise, for early exercising to be justified, American Style option needs to be in the black in a way that the positive carrying on the base position up to the option’s max delivery date is greater than the option’s present value in time. If that is not the case, it’s typically more advantageous to simply trade back the American Style options to capture both the time and the intrinsic value, rather than to exercise them earlier and lose all of the remaining value of the time due to.

OTC FX Options Market OTC FX Options Market

It is the Over the Counter market for currency options operates among major financial institutions and their clients. Trading in forex options generally takes place over the telephone or via electronic systems of dealing between customers of the financial institution and the deal desk and market makers employed by the institution. Dealing desk clients might be seeking to hedge corporate exposures if they represent corporate interests or might be seeking speculative positions in a currency pair using forex options if they are employed by the hedge fund, for instance.

In addition, specialized forex option brokers provide levels of implied volatility as well as the delta level or strike of interest on currency options that reflect their degree of moneyness for the option. This allows currency options market makers to offer accurate quotes.

Once the implied volatility and delta level or strike price for an option transaction has been agreed upon by the broker, the OTC options broker can join the seller and buyer together, if credit lines are in place between potential counterparties to handle the size of the transaction.

In general professional market makers who operate within the OTC FX market will typically have a requirement that any client that comes through their dealing desk has an interest in option that is greater than $1,000,000 in its nominal amount, while an OTC FX options broker would typically be able to assist with options that have notional amounts greater than $5,000,000.

Other methods to trade Currency Options

If you do not qualify for or would prefer not to trade in market OTC market, learning about trading currency options thru other channels may require some research.

For those who prefer the transparency of pricing when transacting derivatives through an exchange, many major exchanges provide liquidity in reasonable amounts to traders to complete currency option transactions.

For starters forex options are traded on futures exchanges like the Chicago International Monetary Market or IMM. These are contracts for currency that are based on futures as such, meaning that the actual asset is not a spot transaction like in the OTC marketplace, however it is typically a futures contract. These contracts typically have standard date of delivery for the quarter for example, the months of March the month of June, September, and December.

Furthermore, certain stock exchanges also offer forex options. One of the most popular examples is the Philadelphia Stock Exchange or PHLX that offers a set of Forex option contracts that are standardized and have monthly delivery dates, which deliver to the spot market, not futures contracts.

A relatively recent trading choice that has increased currency option accessibility to the retail market has been the rise of the FX options broker online. They typically offer markets that are the traditional European and American type options similar to those found in OTC market for currency options, or offer exotic currency options such as binary options to clients seeking to speculate on currency pair movements.