Can you trade options on fx: how are fx options quoted
What are FX Options? – FX Options are financial contracts.
While stock options are mostly traded on exchanges, in the ordinary course of business, FX options are contracts that traders and dealers enter into with one another when they buy and sell to each other.
FX options are financial contracts between traders and dealers
A trader can either buy an FX option from a dealer or sell an FX option to a dealer.
Obligations under a contract are reversed depending on whether the trader is the buyer or the seller.
So what exactly are the rights and obligations involved in this contract?
Well, the buyer is the Holder and the seller is the Writer.
A call option gives the holder the right (but not the obligation) to buy from the writer so many units of a currency at a specified price called the strike price.
A put option gives the holder the right (but not the obligation) to sell to the writer so many units of a currency at a specified price called the strike price.
An option’s size specifies the number of units of currency that one option contract leverages.
Contract sizes are different for options written on different currency pairs.
The base currency is also often called the underlying currency.
If you always buy and sell foreign currencies with your domestic currency and buy and sell foreign-currency options with your domestic currency, you can think of the quoting convention as Foreign/Domestic.
For example, a SPOT price for EUR/USD of 1.5 means that 1 Euro costs $1.5. A EUR/USD call option with a strike price of 1.6 and an ASK price of .02 would cost the buyer $.02 and give him or her the right to purchase Euros at a price of $1.6 per Euro.
With USD as the base currency, a spot price of USD/JPY of 87 means that $1 costs 87 Japanese Yen.
If you are familiar with buying and selling stock options, for FX options, the base, foreign or underlying currency is analogous to the stock.
The quote or domestic currency is analogous to cash.
Common currencies in which a dealer might make a market in currencies and options include these currency pairs and contract sizes:
To incorporate the Base/Quote price-quoting convention into our
definitions, a call option gives the holder the right to buy so many
units of the base currency from the writer at a strike price expressed
in the quote currency.
A put option gives the holder the right to sell to the writer so many units of the base currency at a strike price expressed in the quote currency.
When you sell options, you create a short position.
(Selling options is also spoken of as writing options or granting options.)
A dealer’s price quotes sort options by their strike prices and expiry months and years.
FX options expiry are the prerogative of the dealer.
Typically, options expire in the third week of the month or the end of the month.
Each dealer handles expiration differently.
For the purpose of the Options University, we’ll presume expiration is the third Friday of the expiration month.
European-style options can be exercised only at expiration.
American-style options can be exercised at any time up until expiration and at expiration.
The European-American naming convention has nothing to do with geography. You can buy and sell European- and American-style options anywhere in the world.
Most dealers offer FX options that are European style. They can be exercised only at expiration.
Exercising an options means that you take advantage of your right to buy or sell at the strike price.
If you exercise a call option, you sell your call option for 0 premium and you go long the spot market at the strike price. If you exercise a put option, you sell you put option for 0 premium and you go short the spot market at the strike price.
An option that has time remaining on the contract may still have some value remaining. When you exercise, you sacrifice any remaining time value on the option to be long or short in the spot.
At expiration, there is no more time value so it’s more common to exercise at expiration – hence this is why most dealers offer European-style options.
Dealers quote option prices in the quote currency at a price per unit of the base currency.
The total price that the buyer pays to enter into one contract is the quoted price times the contract size then converted into the dealer’s deposit currency such as dollars, euros or yen.
Dealers quote different ask and bid prices.
An ask price is the price at which the dealer will sell an option.
A bid price is the price at which the dealer will buy an option.
At a given moment in time, for a given option, a dealer’s ask price is always higher than their bid price.
The bid-ask spread is a main source of dealers’ compensation.
Some texts use the words dealer and trader interchangeably.
Here we use dealer to refer to a market-maker or a direct access entity to the marker in FX options.
A dealer is ready, willing and able to be a buyer to all sellers and a seller to all buyers. Dealers quote bid and ask prices.
We use trader to mean a price taker. A trader buys options from a dealer at the dealer’s ask price and sells options to a dealer at the dealer’s bid price.
In all financial markets for all financial instruments, the size of a dealer or exchange’s bid-ask spread is the strongest indicator of an instrument’s liquidity.
The smaller the bid-ask spread, the greater the liquidity.
FX currency markets have some of the greatest liquidity of any financial markets.
A put option gives the holder the right to sell to the writer so many units of the base currency at a strike price expressed in the quote currency.
A call option is said to be “at the money” if the price of the base currency is equal to the option’s strike price.
A call is said to be “out of the money” if the option’s strike price is greater than the market price of the base currency.
Similarly, at a given point in time, a put option is said to be “in the money” if the market price of the base currency is less than the option’s strike price.
A put option is said to be “at the money” if the price of the base currency is equal to the option’s strike price.
A put is said to be “out of the money” if the option’s strike price is less than the market price of the base currency.
Hence, if an option is in the money, it has a positive intrinsic value.
If an option is at the money or out of the money, then it has an intrinsic value of zero.
An option’s time value is the difference between its market price and its intrinsic value:
Time value = Market price – Intrinsic value
The more time until the expiration date (Days to Expiration is often seen as DTE), then presumably the more expensive the option.
If you hold the right to buy something at 1, it would naturally cost more if you could hold onto that right for 1 year rather than 1 month.
The non-intrinsic value is also affected by volatility. If the market place is more volatile, then the chances of its moving up or down (becoming more intrinsic) is increased and thus costs more.
Sometimes the Time Value of an option is referred to as Volatility Value even though their theoretical computation is often discussed separately.
To most options holders, the two are indistinguishable, so referring to either is typically meaning the same – the non-intrinsic value.
Call payoff = Spot price – Strike price
If, at the time a put expires, the Base/Quote spot price is below the option’s strike price, then the option has a positive payoff:
Put payoff = Strike price – Spot price
If an option expires with a positive payoff, then the holder may either exercise the option or accept a cash settlement.
If the holder exercises a call, he or she buys the underlying currency from the writer at the call’s strike price.
If the holder exercises a put, he or she sells the underlying currency to the writer at the put’s strike price.
If the option has a positive payoff and the option settles in cash, then the holder receives from the writer a cash settlement:
Cash settlement = Payoff x Contract size
Keep in mind that both the spot price and the strike price are expressed in the quote currency.
Cash settlement is in the quote currency and is then converted into the dealer’s deposit currency such as dollars, euros or yen.
If an option expires out of the money and worthless or if the payoff is less than the original cost of the option, then the buyer of the option experiences a loss.
If the payoff equals the original cost of the option exactly, then the buyer of the option breaks even.
The holding-period return on a long position in an option is given by the equation:
HPR = (Payoff – Cost of option) / Cost of option
Limited risk refers to the amount of loss but not the likelihood of loss.
If your options expire worthless, you lose the amount of money that you paid for them.
The risk of loss that a short position creates is quite different.
Selling FX call options creates a risk of loss that is uncapped.
If, for $0.25, you sell the right for the holder to buy a Euro from you at a strike price of $2 and, by the time the call expires, the market price of Euros has gone to $3, then you’ve lost $1 minus the $0.25 premium you received.
The higher the price of the base currency goes above the strike price, the more money you lose. In theory, when you are short call options, the risk of loss is unlimited.
The risk of loss that a short position in puts creates is ordinarily larger than the amount of premium you receive from the sale, but the risk is capped.
If, for $1, you sell a put that has a strike price of $20 dollars and the price of the underlying drops to $17, then you lose $20 – $17 + $1 = $2.
Selling a put creates a theoretical maximum risk of loss equal to the put’s strike price minus the sale price of the put.
If, for $1, you sell a put that has a strike price of $20 dollars and the price of the underlying drops to $0, then you lose $20 – $0 + $1 = $19. (Values of currencies rarely if ever drop to zero.)
If you take other, offsetting or limiting positions, your short position is spoken of as covered or hedged.
If you take no offsetting or limiting positions, your short position is spoken of as naked.
When you go short call options, you can manage your risk in different ways.
You can buy the underlying currency and sell a like number of call options on it at a strike price at or higher than the price you paid for the currency.
If the currency price goes above the strike price, then you keep the premium you received for the option but forfeit to the call buyer the gain you would have gotten on the rise in value of the currency above the strike price.
(Buying the underlying currency to cover the calls you sell limits your risk if the price of the currency rises, but if the currency falls in price, you suffer a loss on the value of the currency you hold.)
Alternatively, to limit your risk when you go short call options at one strike price, you can buy a like number of cheaper call options at a higher strike price.
You gain the premium from the sale of the calls at the lower strike price. You pay the lower premium for the calls at the higher strike price.
If the price of the currency rises, your net payout on the exercise of the calls you sold is limited to the difference between the two strike prices.
Similarly, when you go short put options, you can take offsetting positions that limit or hedge your downside risk.
In theory, when a trader goes short put options, he or she, at the same time, could go short a like amount of the underlying currency.
But this is not a good risk-management strategy because, if the value of the currency rises, the trader has unlimited risk of loss from the short sale of the currency.
When going short a put, a more reasonable hedging strategy would be to buy another, cheaper put at a lower strike price.
With this hedging strategy, the trader gains the difference between the two premiums. If the currency declines in price, the trader’s payout is limited to the difference between the two strike prices.
Dealers may lend you as much as 50:1 on all major pairs and 20:1 on all minor pairs.
In general, buying financial assets on margin allows you to leverage your gains.
If, without margin trading, you paid $100 for a financial asset and the value of the asset then went up in value to $120, you would have a gain of $20. On your $100 investment, you would earn a holding period return of 20%.
If, through margin trading, you acquired a $100 financial asset through a $5 deposit to your margin account and the value of the asset then went up in value to $120, you would have a gain of $20. On your $5 investment, you would earn a holding period return of 400% (less the interest expense).
Trading on margin also leverages your risk exposure.
You can lose 100% of your investment. You can lose even more than 100% of your investment.
If, without margin trading, you paid $100 for a financial asset and the value of the asset then went down in value to $95, you would have a loss of $5. On your $100 investment, you would have a holding period return of -5%.
If, through margin trading, you acquired a $100 financial asset through a $5 deposit to your margin account and the value of the asset then went down in value to $95, you would have a loss of $5.
On your $5 investment, you would have a holding period return of -100% (less the interest expense).
If, without margin trading, you paid $100 for a financial asset and the value of the asset then went down in value to $80, you would have a loss of $20.
On your $100 investment, you would have a holding period return of -20%.
If, through margin trading, you acquired a $100 financial asset through a $5 deposit to your margin account and the value of the asset then went down in value to $80, you would have a loss of $20. On your $5 investment, you would have a holding period return of -400% (less the interest expense).
When a dealer allows a trader to trade on margin, initial- and maintenance-margin requirements ensure that the trader—not the dealer— covers any losses.
In trading financial assets on margin in general, the securities you purchase on margin serve as partial collateral for the loan from the dealer. As additional collateral, a dealer requires that you deposit an initial amount of money into a margin account.
This money is called the initial margin. The required amount is expressed as a percentage of the cost of the currency or option.
Hence, your purchase of a security on margin gives your trading account an asset: the security valued at its market value, and a liability: the amount of the loan from the dealer.
Your initial equity interest in the account is equal to the value of the asset minus the liability.
Equity = Asset – Liability
In other words, your initial equity interest in the asset is equal to your initial margin.
For example, to buy a financial asset priced at $100 on an initial margin of 5%, you deposit $5 to your margin account. You own an asset worth $100 and have a liability to the dealer of $95.
(In reality, because of a dealer’s bid-ask spread and the difference between the ask price and the asset’s mark-to-market value, the asset will be valued at slightly less than $100.)
Equity = Asset – Liability
= $100 – $95
= $5
The equity and the asset serve as collateral for the liability.
After you purchase the asset, if the value of the asset goes below a certain level, then the dealer will require you to deposit additional money to your margin account.
The amount of money you are required to maintain in your margin account after the initial purchase is called the maintenance-margin requirement.
For most financial assets, maintenance-margin requirements are expressed this way: If the equity in your account falls below X% of the market value of the assets you hold, then you must contribute more cash to the account until the equity is at least X% of the market value of the asset.
How does that work?
Equity in your margin account has two sources: your cash contributions to the account after the initial margin and gains on the market value of the assets you hold.
Losses on the assets you hold reduce the equity in your margin account. Any cash withdrawals from your margin account also reduce your equity in the account.
If losses in the market value of the financial asset bring the equity in the account below the maintenance-margin requirement, then additional contributions to the margin account are required.
The additional contributions bring your equity back up to the required level.
In the table below, we show the simplified purchase on margin of a financial asset at a price of $100. (We omit interest charges on the margin loan.) The initial margin requirement is 5%. The maintenance-margin requirement is 5%.
Using easy numbers, the value of the asset goes up and then, with one bounce, goes down to $0.
Read through the table day by day.
So long as the market value of the financial asset is above its initial value, equity as a percent of the asset’s market value is equal to or greater than 5%.
When losses take the equity in the account below 5% of the market value of the asset, contributions to the margin account are made sufficient to bring equity back up to 5% of the market value of the asset.
For example, look at the transition from day 9 to day 10. At the end of day 9, equity is $2. On day 10, the market value of the asset loses $20. The loss drops the equity from $2 to -$18. End-of-day-10 required equity is 5% of $20 or $1. To get equity from $18 to the required $1, a contribution to the margin account of $19 is required.
In effect, the initial-margin contribution pays for 5% of the initial
value of the asset. Subsequent maintenance-margin contributions pay for
95% of the value of losses from initial value.
If losses total $100, then the initial margin contribution is $5 and maintenance-margin contributions total $95.
By the time the market value goes from $100 to $0.00, the trader has contributed a total of $100 to his or her margin account. The trader has lost $100.
If your equity falls below the maintenance-margin requirement and you do not contribute additional cash to your margin account as promptly as the dealer requires, then the dealer may sell all or a portion of your financial assets sufficient to meet the margin requirement.
In general, with the maintenance-margin requirement expressed as equity as a percentage of market value, if the market value of the financial asset goes to zero, then contributions to the margin account will have been made equal to the original cost of the financial asset. .
Margin requirements for buying and selling FX options serve the same purpose as they do for trading other financial assets: The options plus the trader’s contributions to the margin account serve as collateral to protect the dealer from exposure to actual or potential losses that arise or may arise out of the option trades.
The risk of loss that the purchase of FX options creates is limited to the value of the options.
Selling FX call options, however, creates a risk of loss that is, at least in theory, unlimited. (If, for $0.25, you sell the right to buy a Euro from you at a strike price of $2 and, by the time the call expires, the market price of Euros has gone to $1,000,002, then you’ve lost $1 million minus the $0.25 premium you received.) Selling a put option creates a theoretical risk of loss equal to the put’s strike price minus the sale price of the put. (If, for $1, you sell a put with a strike price of $20 dollars and the price of the underlying drops to $0, then you lose $20 – $1 = $19.
Dealers do not require traders to put up margin equivalent to the theoretical limits of options’ risk exposures. Instead, dealers examine likely potential one-day losses that option positions create.
When traders trade FX options and currencies, they frequently enter into a position that combines the purchase or sale of a currency with purchases and/or sales of multiple options.
To calculate initial margin requirement for an FX option trade that combines currencies and/or options and purchases and/or sales, a dealer runs the combined positions that the trade would create through sixteen different market scenarios.
Different scenarios feature different combinations of increasing and decreasing currency price and increasing, decreasing and steady underlying currency price volatility. (The greater the volatility, the greater potential losses— and profits.)
For each scenario, the dealer calculates the potential one-day loss of the combined positions. The potential one-day loss of the scenario that produces the greatest one-day loss becomes the margin requirement for the trade combination into which the trader has entered.
Likewise, to calculate maintenance-margin requirements, each day a dealer runs a trader’s positions through sixteen different market scenarios. For each scenario, the calculator calculates the potential one-day loss of the positions.
The potential one-day loss of the scenario that produces the greatest one-day loss becomes the margin requirement for the day.
Margin trading is a powerful tool. Use it accordingly.
While stock options are mostly traded on exchanges, in the ordinary course of business, FX options are contracts that traders and dealers enter into with one another when they buy and sell to each other.
FX options are financial contracts between traders and dealers
A trader can either buy an FX option from a dealer or sell an FX option to a dealer.
Obligations under a contract are reversed depending on whether the trader is the buyer or the seller.
So what exactly are the rights and obligations involved in this contract?
Well, the buyer is the Holder and the seller is the Writer.
Call & Put Options
The two fundamental types of FX options are CALLS and PUTS.A call option gives the holder the right (but not the obligation) to buy from the writer so many units of a currency at a specified price called the strike price.
A put option gives the holder the right (but not the obligation) to sell to the writer so many units of a currency at a specified price called the strike price.
- What is the STRIKE PRICE?
Strike Price, also known as the “exercise price,” is the stated price at which the buyer of a call has the right to buy a specific currency, or the stated price at which the buyer of a put has the right to sell a specific currency
Size Matters
Contract sizeAn option’s size specifies the number of units of currency that one option contract leverages.
Contract sizes are different for options written on different currency pairs.
Currency Pairs
Like FX currency contracts, FX option contracts are quoted in BASE/QUOTE currency pairs.The base currency is also often called the underlying currency.
If you always buy and sell foreign currencies with your domestic currency and buy and sell foreign-currency options with your domestic currency, you can think of the quoting convention as Foreign/Domestic.
For example, a SPOT price for EUR/USD of 1.5 means that 1 Euro costs $1.5. A EUR/USD call option with a strike price of 1.6 and an ASK price of .02 would cost the buyer $.02 and give him or her the right to purchase Euros at a price of $1.6 per Euro.
With USD as the base currency, a spot price of USD/JPY of 87 means that $1 costs 87 Japanese Yen.
If you are familiar with buying and selling stock options, for FX options, the base, foreign or underlying currency is analogous to the stock.
The quote or domestic currency is analogous to cash.
Common currencies in which a dealer might make a market in currencies and options include these currency pairs and contract sizes:
| Base/Quote | Currencies | Contract size |
| AUD/USD | Australian vs. US | 100,000 |
| CAD/USD | Canadian vs. US | 100,000 |
| CHF/USD | Swiss vs. US | 100,000 |
| EUR/USD | Euro vs US | 100,000 |
| GPB/USD | Pound vs US | 100,000 |
| JPY/USD | Yen vs US | 100,000 |
| NZD/USD | New Zealand vs US | 100,000 |
| AUD/JPY | Australian vs Yen | 100,000 |
| CAD/JPY | Canadian vs Yen | 100,000 |
| CHF/JPY | Swiss vs Yen | 100,000 |
| EUR/JPY | Euro vs Yen | 100,000 |
| GPB/JPY | Pound vs Yen | 100,000 |
| USD/JPY | US vs Yen | 100,000 |
| AUD/CAD | Australian vs Canada | 100,000 |
| EUR/CAD | Euro vs Canada | 100,000 |
| USD/CAD | US vs Canada | 100,000 |
| EUR/CHF | Euro vs Swiss | 100,000 |
| GPB/CHF | Pound vs Swiss | 100,000 |
| USD/CHF | US vs Swiss | 100,000 |
| EUR/AUD | Euro vs Australian | 100,000 |
| EUR/GBP | Euro vs Pound | 100,000 |
| AUD/NZD | Australian vs New Zealand | 100,000 |
A put option gives the holder the right to sell to the writer so many units of the base currency at a strike price expressed in the quote currency.
Long and Short Positions
When you buy options, you create a long position.When you sell options, you create a short position.
(Selling options is also spoken of as writing options or granting options.)
- If you think a currency’s price will rise, buy calls or sell puts. If you think a currency’s price will fall, buy puts or sell calls.
- If you believe the price of a base currency is likely to rise relative to a quote currency, then, as a simple trading strategy, you may want to buy calls or sell puts. That is, you may want to go long calls or short puts.
- If you believe the price of a base currency is likely to fall relative to a quote currency, then you may want to buy— go long— puts or sell— go short— calls.
- If you buy an FX call or a put, you pay for the option in the quote currency. If you sell an FX call or put, you are paid for it in the quote currency.
FX Options Expire
For a given currency pair, dealers quote prices for options that have different strike prices and expiration dates.A dealer’s price quotes sort options by their strike prices and expiry months and years.
FX options expiry are the prerogative of the dealer.
Typically, options expire in the third week of the month or the end of the month.
Each dealer handles expiration differently.
For the purpose of the Options University, we’ll presume expiration is the third Friday of the expiration month.
Most Dealers Offer FX Options That Are European-style, Not American
Options come in two styles: European style and American style.European-style options can be exercised only at expiration.
American-style options can be exercised at any time up until expiration and at expiration.
The European-American naming convention has nothing to do with geography. You can buy and sell European- and American-style options anywhere in the world.
Most dealers offer FX options that are European style. They can be exercised only at expiration.
Exercising an options means that you take advantage of your right to buy or sell at the strike price.
If you exercise a call option, you sell your call option for 0 premium and you go long the spot market at the strike price. If you exercise a put option, you sell you put option for 0 premium and you go short the spot market at the strike price.
An option that has time remaining on the contract may still have some value remaining. When you exercise, you sacrifice any remaining time value on the option to be long or short in the spot.
At expiration, there is no more time value so it’s more common to exercise at expiration – hence this is why most dealers offer European-style options.
Dealers Quote Bid and Ask Prices
An option’s price or premium is the amount of money the buyer pays to enter into the contract.Dealers quote option prices in the quote currency at a price per unit of the base currency.
The total price that the buyer pays to enter into one contract is the quoted price times the contract size then converted into the dealer’s deposit currency such as dollars, euros or yen.
Dealers quote different ask and bid prices.
An ask price is the price at which the dealer will sell an option.
A bid price is the price at which the dealer will buy an option.
At a given moment in time, for a given option, a dealer’s ask price is always higher than their bid price.
The bid-ask spread is a main source of dealers’ compensation.
Some texts use the words dealer and trader interchangeably.
Here we use dealer to refer to a market-maker or a direct access entity to the marker in FX options.
A dealer is ready, willing and able to be a buyer to all sellers and a seller to all buyers. Dealers quote bid and ask prices.
We use trader to mean a price taker. A trader buys options from a dealer at the dealer’s ask price and sells options to a dealer at the dealer’s bid price.
In all financial markets for all financial instruments, the size of a dealer or exchange’s bid-ask spread is the strongest indicator of an instrument’s liquidity.
The smaller the bid-ask spread, the greater the liquidity.
FX currency markets have some of the greatest liquidity of any financial markets.
FX Call and Put Contract Specifications
An FX CALL-OPTION contract has these specifications:
- Base/Quote currency pair
- Strike price: The price expressed in the quote currency at which the holder is entitled to buy the base currency from the writer
- Contract size: The number of units of the base currency that the holder is entitled to buy from the writer
- Expiration date
- Style: European or American
- Option price or premium to be paid in quote currency
An FX PUT-OPTION contract has these specifications:
- Base/Quote currency pair
- Strike price: The price expressed in the quote currency at which the holder is entitled to sell the base currency to the writer
- Contract size: The number of units of the base currency that the holder is entitled to sell to the writer
- Expiration date
- Style: European or American
- Option price or premium to be paid in quote currency
A put option gives the holder the right to sell to the writer so many units of the base currency at a strike price expressed in the quote currency.
In the Money, At the Money or Out of the Money
At a given point in time, a call option is said to be “in the money” if the market price of the base currency is greater than the option’s strike price.A call option is said to be “at the money” if the price of the base currency is equal to the option’s strike price.
A call is said to be “out of the money” if the option’s strike price is greater than the market price of the base currency.
Similarly, at a given point in time, a put option is said to be “in the money” if the market price of the base currency is less than the option’s strike price.
A put option is said to be “at the money” if the price of the base currency is equal to the option’s strike price.
A put is said to be “out of the money” if the option’s strike price is less than the market price of the base currency.
Intrinsic and Time Value
At any given point in time, an option’s intrinsic value is the value the option would have if it expired at that moment.Hence, if an option is in the money, it has a positive intrinsic value.
If an option is at the money or out of the money, then it has an intrinsic value of zero.
An option’s time value is the difference between its market price and its intrinsic value:
Time value = Market price – Intrinsic value
The more time until the expiration date (Days to Expiration is often seen as DTE), then presumably the more expensive the option.
If you hold the right to buy something at 1, it would naturally cost more if you could hold onto that right for 1 year rather than 1 month.
The non-intrinsic value is also affected by volatility. If the market place is more volatile, then the chances of its moving up or down (becoming more intrinsic) is increased and thus costs more.
Sometimes the Time Value of an option is referred to as Volatility Value even though their theoretical computation is often discussed separately.
To most options holders, the two are indistinguishable, so referring to either is typically meaning the same – the non-intrinsic value.
Put and Call Payoffs and Cash Settlements
If, at the time a call expires, the Base/Quote spot price is above the option’s strike price, then the option has a positive payoff:Call payoff = Spot price – Strike price
If, at the time a put expires, the Base/Quote spot price is below the option’s strike price, then the option has a positive payoff:
Put payoff = Strike price – Spot price
If an option expires with a positive payoff, then the holder may either exercise the option or accept a cash settlement.
If the holder exercises a call, he or she buys the underlying currency from the writer at the call’s strike price.
If the holder exercises a put, he or she sells the underlying currency to the writer at the put’s strike price.
If the option has a positive payoff and the option settles in cash, then the holder receives from the writer a cash settlement:
Cash settlement = Payoff x Contract size
Keep in mind that both the spot price and the strike price are expressed in the quote currency.
Cash settlement is in the quote currency and is then converted into the dealer’s deposit currency such as dollars, euros or yen.
FX option profits and returns
If an option produces a payoff that is greater than the original cost of the option, then the buyer of the option earns a profit.If an option expires out of the money and worthless or if the payoff is less than the original cost of the option, then the buyer of the option experiences a loss.
If the payoff equals the original cost of the option exactly, then the buyer of the option breaks even.
The holding-period return on a long position in an option is given by the equation:
HPR = (Payoff – Cost of option) / Cost of option
Risk
The risk of loss that a long position in FX options creates is limited to the value of the options.Limited risk refers to the amount of loss but not the likelihood of loss.
If your options expire worthless, you lose the amount of money that you paid for them.
The risk of loss that a short position creates is quite different.
Selling FX call options creates a risk of loss that is uncapped.
If, for $0.25, you sell the right for the holder to buy a Euro from you at a strike price of $2 and, by the time the call expires, the market price of Euros has gone to $3, then you’ve lost $1 minus the $0.25 premium you received.
The higher the price of the base currency goes above the strike price, the more money you lose. In theory, when you are short call options, the risk of loss is unlimited.
The risk of loss that a short position in puts creates is ordinarily larger than the amount of premium you receive from the sale, but the risk is capped.
If, for $1, you sell a put that has a strike price of $20 dollars and the price of the underlying drops to $17, then you lose $20 – $17 + $1 = $2.
Selling a put creates a theoretical maximum risk of loss equal to the put’s strike price minus the sale price of the put.
If, for $1, you sell a put that has a strike price of $20 dollars and the price of the underlying drops to $0, then you lose $20 – $0 + $1 = $19. (Values of currencies rarely if ever drop to zero.)
Naked versus covered or hedged short option positions
When you go short calls or puts, you can either take other positions that limit the risk of the short position or not.If you take other, offsetting or limiting positions, your short position is spoken of as covered or hedged.
If you take no offsetting or limiting positions, your short position is spoken of as naked.
When you go short call options, you can manage your risk in different ways.
You can buy the underlying currency and sell a like number of call options on it at a strike price at or higher than the price you paid for the currency.
If the currency price goes above the strike price, then you keep the premium you received for the option but forfeit to the call buyer the gain you would have gotten on the rise in value of the currency above the strike price.
(Buying the underlying currency to cover the calls you sell limits your risk if the price of the currency rises, but if the currency falls in price, you suffer a loss on the value of the currency you hold.)
Alternatively, to limit your risk when you go short call options at one strike price, you can buy a like number of cheaper call options at a higher strike price.
You gain the premium from the sale of the calls at the lower strike price. You pay the lower premium for the calls at the higher strike price.
If the price of the currency rises, your net payout on the exercise of the calls you sold is limited to the difference between the two strike prices.
Similarly, when you go short put options, you can take offsetting positions that limit or hedge your downside risk.
In theory, when a trader goes short put options, he or she, at the same time, could go short a like amount of the underlying currency.
But this is not a good risk-management strategy because, if the value of the currency rises, the trader has unlimited risk of loss from the short sale of the currency.
When going short a put, a more reasonable hedging strategy would be to buy another, cheaper put at a lower strike price.
With this hedging strategy, the trader gains the difference between the two premiums. If the currency declines in price, the trader’s payout is limited to the difference between the two strike prices.
Margin trading leverages potential gains— and losses
Most dealers allow traders to trade on margin. That is, they lend you at interest a substantial portion of the money with which to purchase currencies and options.Dealers may lend you as much as 50:1 on all major pairs and 20:1 on all minor pairs.
In general, buying financial assets on margin allows you to leverage your gains.
If, without margin trading, you paid $100 for a financial asset and the value of the asset then went up in value to $120, you would have a gain of $20. On your $100 investment, you would earn a holding period return of 20%.
If, through margin trading, you acquired a $100 financial asset through a $5 deposit to your margin account and the value of the asset then went up in value to $120, you would have a gain of $20. On your $5 investment, you would earn a holding period return of 400% (less the interest expense).
Trading on margin also leverages your risk exposure.
You can lose 100% of your investment. You can lose even more than 100% of your investment.
If, without margin trading, you paid $100 for a financial asset and the value of the asset then went down in value to $95, you would have a loss of $5. On your $100 investment, you would have a holding period return of -5%.
If, through margin trading, you acquired a $100 financial asset through a $5 deposit to your margin account and the value of the asset then went down in value to $95, you would have a loss of $5.
On your $5 investment, you would have a holding period return of -100% (less the interest expense).
If, without margin trading, you paid $100 for a financial asset and the value of the asset then went down in value to $80, you would have a loss of $20.
On your $100 investment, you would have a holding period return of -20%.
If, through margin trading, you acquired a $100 financial asset through a $5 deposit to your margin account and the value of the asset then went down in value to $80, you would have a loss of $20. On your $5 investment, you would have a holding period return of -400% (less the interest expense).
When you trade on margin …
When you trade on margin, the financial assets you hold plus the equity in your margin account serve as collateral for the loan you receive from the dealer. They protect the dealer against losses on the loan.When a dealer allows a trader to trade on margin, initial- and maintenance-margin requirements ensure that the trader—not the dealer— covers any losses.
In trading financial assets on margin in general, the securities you purchase on margin serve as partial collateral for the loan from the dealer. As additional collateral, a dealer requires that you deposit an initial amount of money into a margin account.
This money is called the initial margin. The required amount is expressed as a percentage of the cost of the currency or option.
Hence, your purchase of a security on margin gives your trading account an asset: the security valued at its market value, and a liability: the amount of the loan from the dealer.
Your initial equity interest in the account is equal to the value of the asset minus the liability.
Equity = Asset – Liability
In other words, your initial equity interest in the asset is equal to your initial margin.
For example, to buy a financial asset priced at $100 on an initial margin of 5%, you deposit $5 to your margin account. You own an asset worth $100 and have a liability to the dealer of $95.
(In reality, because of a dealer’s bid-ask spread and the difference between the ask price and the asset’s mark-to-market value, the asset will be valued at slightly less than $100.)
Equity = Asset – Liability
= $100 – $95
= $5
The equity and the asset serve as collateral for the liability.
After you purchase the asset, if the value of the asset goes below a certain level, then the dealer will require you to deposit additional money to your margin account.
The amount of money you are required to maintain in your margin account after the initial purchase is called the maintenance-margin requirement.
For most financial assets, maintenance-margin requirements are expressed this way: If the equity in your account falls below X% of the market value of the assets you hold, then you must contribute more cash to the account until the equity is at least X% of the market value of the asset.
How does that work?
Equity in your margin account has two sources: your cash contributions to the account after the initial margin and gains on the market value of the assets you hold.
Losses on the assets you hold reduce the equity in your margin account. Any cash withdrawals from your margin account also reduce your equity in the account.
If losses in the market value of the financial asset bring the equity in the account below the maintenance-margin requirement, then additional contributions to the margin account are required.
The additional contributions bring your equity back up to the required level.
In the table below, we show the simplified purchase on margin of a financial asset at a price of $100. (We omit interest charges on the margin loan.) The initial margin requirement is 5%. The maintenance-margin requirement is 5%.
Using easy numbers, the value of the asset goes up and then, with one bounce, goes down to $0.
Read through the table day by day.
So long as the market value of the financial asset is above its initial value, equity as a percent of the asset’s market value is equal to or greater than 5%.
When losses take the equity in the account below 5% of the market value of the asset, contributions to the margin account are made sufficient to bring equity back up to 5% of the market value of the asset.
For example, look at the transition from day 9 to day 10. At the end of day 9, equity is $2. On day 10, the market value of the asset loses $20. The loss drops the equity from $2 to -$18. End-of-day-10 required equity is 5% of $20 or $1. To get equity from $18 to the required $1, a contribution to the margin account of $19 is required.
| Day | Market Value |
Contribution to margin account |
Liability | Equity | Equity as % of Market Value |
| 0 |
$100.00
|
Initial margin: $5.00 |
95.00
|
5.00
|
5% |
| 1 |
$110.00
|
95.00
|
15.00
|
14% | |
| 2 |
$120.00
|
95.00
|
25.00
|
21% | |
| 3 |
$140.00
|
95.00
|
45.00
|
32% | |
| 4 |
$150.00
|
95.00
|
55.00
|
37% | |
| 5 |
$160.00
|
95.00
|
65.00
|
41% | |
| 6 |
$120.00
|
95.00
|
25.00
|
21% | |
| 7 |
$100.00
|
95.00
|
5.00
|
5% | |
| 8 |
$80.00
|
19.00
|
95.00
|
4.00
|
5% |
| 9 |
$40.00
|
38.00
|
95.00
|
2.00
|
5% |
| 10 |
$20.00
|
19.00
|
95.00
|
1.00
|
5% |
| 11 |
$40.00
|
95.00
|
21.00
|
53% | |
| 12 |
$20.00
|
95.00
|
1.00
|
5% | |
| 13 |
$8.00
|
11.40
|
95.00
|
0.40
|
5% |
| 14 |
$4.00
|
3.80
|
95.00
|
0.20
|
5% |
| 15 |
2.00
|
1.90
|
95.00
|
0.10
|
5% |
| 16 |
1.00
|
0.95
|
95.00
|
0.05
|
5% |
| 17 |
0.40
|
0.57
|
95.00
|
0.02
|
5% |
| 18 |
0.20
|
0.19
|
95.00
|
0.01
|
5% |
| 19 |
0.10
|
0.0950
|
95.00
|
0.0050
|
5% |
| 20 |
0.01
|
0.0855
|
95.00
|
0.0005
|
5% |
| 21 |
0.00
|
0.0095
|
95.00
|
0.0000
|
|
| Total Contribution: $100.00 |
If losses total $100, then the initial margin contribution is $5 and maintenance-margin contributions total $95.
By the time the market value goes from $100 to $0.00, the trader has contributed a total of $100 to his or her margin account. The trader has lost $100.
If your equity falls below the maintenance-margin requirement and you do not contribute additional cash to your margin account as promptly as the dealer requires, then the dealer may sell all or a portion of your financial assets sufficient to meet the margin requirement.
In general, with the maintenance-margin requirement expressed as equity as a percentage of market value, if the market value of the financial asset goes to zero, then contributions to the margin account will have been made equal to the original cost of the financial asset. .
Margin requirements for FX options vary…
They depend on currency volatility and on the risk exposures of the combined positions you take.Margin requirements for buying and selling FX options serve the same purpose as they do for trading other financial assets: The options plus the trader’s contributions to the margin account serve as collateral to protect the dealer from exposure to actual or potential losses that arise or may arise out of the option trades.
The risk of loss that the purchase of FX options creates is limited to the value of the options.
Selling FX call options, however, creates a risk of loss that is, at least in theory, unlimited. (If, for $0.25, you sell the right to buy a Euro from you at a strike price of $2 and, by the time the call expires, the market price of Euros has gone to $1,000,002, then you’ve lost $1 million minus the $0.25 premium you received.) Selling a put option creates a theoretical risk of loss equal to the put’s strike price minus the sale price of the put. (If, for $1, you sell a put with a strike price of $20 dollars and the price of the underlying drops to $0, then you lose $20 – $1 = $19.
Dealers do not require traders to put up margin equivalent to the theoretical limits of options’ risk exposures. Instead, dealers examine likely potential one-day losses that option positions create.
When traders trade FX options and currencies, they frequently enter into a position that combines the purchase or sale of a currency with purchases and/or sales of multiple options.
To calculate initial margin requirement for an FX option trade that combines currencies and/or options and purchases and/or sales, a dealer runs the combined positions that the trade would create through sixteen different market scenarios.
Different scenarios feature different combinations of increasing and decreasing currency price and increasing, decreasing and steady underlying currency price volatility. (The greater the volatility, the greater potential losses— and profits.)
For each scenario, the dealer calculates the potential one-day loss of the combined positions. The potential one-day loss of the scenario that produces the greatest one-day loss becomes the margin requirement for the trade combination into which the trader has entered.
Likewise, to calculate maintenance-margin requirements, each day a dealer runs a trader’s positions through sixteen different market scenarios. For each scenario, the calculator calculates the potential one-day loss of the positions.
The potential one-day loss of the scenario that produces the greatest one-day loss becomes the margin requirement for the day.
Margin trading is a powerful tool. Use it accordingly.
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