FX Options or Forex Options are derivative financial instruments. With an FX Option, you gain the right to buy or sell a fixed amount of currency at a specific rate on a predetermined future date. Upon contract formation, the buyer (or holder) of the FX Option has to pay a fee to the seller for acquiring the option. This fee is called the Premium.
We can understand FX Options as commitments to future transactions in forward contracts, for predetermined prices. What is important is that the buyer of an FX Option has no obligation to exercise his right whereas the seller is bound to the contract if the holder declares to exercise his option.
FX Option Pricing
From the holder’s point of view, an FX Option contract fulfils the same purpose as an insurance policy. The probability of a claim being made determines the cost of the insurance. This price is usually calculated by using statistical assumptions. They map the probability that the holder will use the policy in the future as well as the expected loss for the issuing company. Likewise, the price of Forex Options also tries to represent the measure of risk which is involved for the seller.
The price of the currency option, the Premium, can be split into two different components, the intrinsic value and the time value. The intrinsic value is the difference between the current FX spot price and the strike price of the option. We call the excess part of the Premium the time value. It’s the difference between the Premium and the intrinsic value.
Jargon FX Option Trading
|In-The-Money||If an option has intrinsic value, we say that the option is In-The-Money (ITM)|
|Out-Of-The-Money||if an option has no intrinsic value, we say the option is Out-Of-The-Money (OTM)|
|At-The-Money||The strike price and the current spot exchange rate are equal (ATM)|
A currency option will be worthless if it is OTM or ATM on its expiration date. Therefore, the holder will allow the option to expire.
The intrinsic value is the amount of money we could realise through exercising our option, under assumption that the FX spot rate will equal the current rate on the expiration date. The reason is that the time value will always be zero when the currency option expires. Hence, a Forex call option has intrinsic value if the FX spot price is above its strike price. A Forex put option has intrinsic value if the FX spot price is below its strike price.
The calculation of the time value is far more complex. The reason is that many parameters influence the time value. The most important parameters are the volatility of the underlying currencies and the time left until the expiration. But even the difference in the interest rates between the two currencies has to be addressed. Such interest rate differentials which are embedded in currency trades are called FX swap rates.
The closer the expiry date gets, the more the time value declines. At the expiration, it is zero. The time value of an option is maximal when the option is At-The-Money. At this moment, the complete Premium equals the time value and there’s no intrinsic value.
The most common statistical method for European FX Option pricing follows the Garman-Kohlhagen model which calculates a log-normal process.
Advantages and Risks of FX Options
Traders: Fixing potential risks
If the FX rate moves against our own position in the FX Spot market, we will have a loss. By acquiring a Forex Option, we can remove the risks of unpredictable losses; our loss will always be limited to the Premium.
This works like an insurance contract. If the market moves against us, the option protects us against the loss. On the other hand, we can still profit from advantageous FX rates should the market move in our favour.
Because we know our maximal loss before, position sizing in the spot market can happen with predefined strategies. Another advantage for traders is that they can work without stop-losses for open positions in the spot market. The seller of the option will pay the losses if they occur.
Hedging with FX Options
This type of option is also extremely useful for hedging FX risk in portfolios when the direction of movements in exchange rates remains uncertain for some time. That’s why Forex Options are interesting financial derivatives especially for portfolio managers. Currency market turbulences and heavy exchange rate fluctuations can happen due to unforeseen events in World economy or politics. By utilising FX Options, we can protect ourselves against these sudden movements in exchange rates.
Contrary to the purchaser, the option seller’s risk is potentially unlimited. He will always receive the fixed Premium for taking over the risk. That’s why Option sellers need a huge amount of liquidity.
FX Call and FX Put
Two different types of options exist per FX pair because of the two underlying currencies. The purchaser of a FX Call Option has the right to buy the underlying currency. The seller of the Call Option has the obligation to sell the underlying currency if the purchaser exercises his right. An FX Put Option gives the purchaser the right to sell the underlying currency. The seller of the Put Option has the obligation to sell the underlying currency if the purchaser exercises his right.
In all FX transactions, one currency is purchased and another currency is sold. Therefore, every single currency pair trades both as a Call and Put.
European FX Options vs American FX Options
European FX Options may only be exercised on the expiration date and not earlier. American FX Options are more flexible. They may be exercised at any time until their expiry dates.
Forex Option Contracts – Important Terms
The strike price or exercise price is the price at which the option buyer has the right to either buy or sell the underlying currency. The strike price has to be determined in advance and is part of the option contract.
The expiry date (expiration date) is the last date at which the option may be exercised. After this date, the option contract expires.
Only relevant if the option is exercised. It’s the date when the currency exchange actually happens.
The cost of purchasing the FX Option. The buyer has to pay up front for the Premium, at the time of purchase. The Premium is calculated based on risk assumptions and depends on different factors. For instance, the difference between the current price and strike price of the underlying FX rate, and the time between the purchase and the expiry are important.
Exercising the option means using the right which has been granted by buying the option. If the buyer decides to exercise the option, then the seller will be informed and the guaranteed FX transaction will happen.
A European EUR/USD option could give the holder the right to sell €1,000,000 and buy $1,200,000 on December 01. Here, the agreed strike price is EUR/USD 1.20.
If the exchange rate is lower than 1.20 on December 01, then the holder will exercise the option. If the EUR/USD rate drops to 1.15, then his profit in USD is (1.20 – 1.15) x 1,000,000 = 50,000 if he uses the option. Also, he can buy back EUR in the spot market at a lower exchange rate of 1.15 then. As you can see, the upside risk in EUR/USD is eliminated by paying the Premium. At the same time, the holder can still profit from a drop of the currency rate.