Use
the menu below to learn the basics of trading in options:
Application
In spite of the fact that currency options
are becoming more and more popular, there is still some client
resistance to using currency options to manage currency exposure.
Some clients consider currency options t be expensive and /
or speculative. More sophisticated clients have, however, made
options an important part of their forex exposure management
strategies, just like us here at Mandus Invest SA.
When you buy an option, the most you can lose is the premium
or price you paid for the currency option. In some cases, currency
options can help minimize downside risk, while allowing participation
in the upside potential.
Clients who buy currency options enjoy protection from unfavourable
exchange rate movements and may benefit from favourable exchange
rate movements. Currency options can also be used to hedge different
types of exposures or use as a tool to enhance yield. Sometimes,
a strategy may involve more than one option and some option
strategies employ multiple and complex combinations. Certain
combinations can yield a low or no-cost currency option strategy
by trading off the premium spent on buying a currency option
with the premium earned by selling a currency option.
Buying currency options may assist a client by:
- Limiting downside fluctuation risk & retaining upside
potential
- Providing unlimited potential for gain
- Providing a hedge for a contingent risk
- Enabling planning with more certainty
Selling currency options may assist a client by:
- Providing immediate income from premium
received
- Providing flexibility when used with
other tools as part of an exchange rate strategy.
Brief
history
The currency options market shares its origins
with the new markets in derivative products, which have blossomed
in the past fifteen years, or so. They were developed to cope
with the rise in volatility in the financial markets worldwide.
In the foreign exchange markets, the dramatic rise (1983 to
1985) and the subsequent fall (1985 to 1987) in the dollar caused
major problems for Central Banks, corporate treasurers, and
international investors alike. Windfall forex losses became
enormous for the treasurer who failed to hedge, or who hedged
too soon, or who borrowed money in the wrong currency. The investor
in the international bond market soon discovered that the risk
on their bond position could appear insignificant relative to
their currency exposure.
Therefore, currency options were developed, not as another interesting
off-balance sheet trading vehicle but as an alternative risk
management tool to the spot and forward forex markets. They
are a product of currency market volatility and owe their existence
to the demands of foreign exchange users for alternative hedging
and exposure management techniques.
Characteristics
Currency options are not merely insurance
contracts against exchange risk but they are above all financial
assets that can be bought and sold just like tradable securities.
Options may be combined so that their asymmetric payouts tailor
a defined risk profile. Some combinations are primarily trading
strategies, but option combinations can also be a useful tool.
For example, for investors to construct a strategy allowing
them to take advantage of a particular view that they have about
a market direction. Other strategies allow purchasers to give
up some of the benefits they may have received in market movements
in return for a reduced premium payment. In our case, at Mandus
Invest SA we use currency options as a stop-loss measure.
The market today is characterised
by:
- Traded in its listed form mainly in Philadelphia
and Chicago
- An efficient market place
- Liquid over-the-counter (OTC) market
- Global 24 /7 market place
- Defined risk profiles
- Risk limitation and unlimited profit
potential
Conclusions
Currency options are not merely insurance
contracts against foreign exchange risk but they are above all
financial assets that can be bought and sold just like tradable
securities. Options may be combined so that their asymmetric
payouts tailor a defined risk profile. Some combinations are
primarily trading strategies, but option combinations can also
be a useful tool. For example, for investors to construct a
strategy allowing them to take advantage of a particular view
that they have about a market direction. Other strategies allow
purchasers to give up some of the benefits they may have received
in market movements in return for a reduced premium payment.
It must be remembered that by buying a call and simultaneously
selling a put with the same maturity date and the same strike
is equivalent to entering into a forward contract.
But above all, remember the following
risk profile of options:
- Long option: unlimited profit potential – limited risk
- Short option: unlimited risk – limited profit potential
Definitions
The most important factor of an option,
in comparison to a foreign exchange transaction, is that the
buyer has the right but not the obligation to buy or sell a
specified quantity of a currency at a specified rate on or before
a specified date. For this right, the buyer pays a premium to
the seller or writer of the currency option, usually at the
outset. For currency options, the premium is often expressed
as a percentage of the notional amount covered.
The terms used in the options market
can be confusing, but the principle terms or jargon used can
be summarised as:
- The option buyer is the buyer and the
seller the writer
- A call gives the buyer the right to buy
a specific quantity of a currency at an agreed rate trover
a given period
- A put gives the buyer the right to sell
a specific quantity of a currency at an agreed rate trover
a given period
- The premium is the price paid for the
option. With a currency option this can be expressed trin
different ways and is usually paid with spot value from the
initial deal date
- The principle amount is the amount of
currency which the buyer can buy or sell
- Exercise is the process by which the
option is converted into an underlying foreign trexchange
contract
- xpiry date is the final date on which
the option may be exercised
- A European style option can be exercised
at any time but the funds will be transferred on trthe maturity
date. In practice, most European style options are not exercised
until the expiry trdate
- An American style option can be exercised
at any time up to and including the expiry date trwith the
funds being transferred with spot value from exercise. ential
It is important to note, that due to the
nature of foreign exchange, all currency options are a put on
one currency and a call on another. For example, a dollar call
/ Swiss franc put gives the buyer the right to buy dollars and
the right to sell Swiss francs.
Market
Conventions
How should one ask for an option
price? The required pieces of information, in the preferred
order, are as follows:
- The two currencies involved and which is the put and which
is the call, e.g. dollar put, Swiss franc call
- The period, e.g. two months or the expiry or delivery date,
e.g. expiry 12th December, for delivery 14th December
- The strike, e.g. 1.5010
- The style, e.g. European or American style
- The amount, e.g. 10 million dollars
There are many ways of stating the period, but usually, if one
date is stated, it is assumed to be the expiry date but it is
much safer to always specify. In the same way, if a ten day
option is requested, it is assumes that the required option
has an expiry date ten days from the current date. If, however,
an option is requested with a period in terms of months or years,
e.g. three months, the dates of the option are worked out as
follows:
- Calculate the spot date for that currency pair, using the
same conventions as the spot mmarket
- Take the period, e.g. three months form that date, using
the forward market conventions
This gives the delivery date. The expiry date will
then usually be two working days before that. Please note: With
cross currencies and dates involving American holidays or in
any case where there may be confusion, it is always best to
quote both the expiry and delivery dates required.
In asking for an option price, always state which currency is
the call and which is the put. For example, does dollar Swiss
franc (usd/sfr) put mean a dollar put or a Swiss franc put?
This would usually refer to a Swiss franc put dollar call. However,
most clients would probably mean a dollar put. For this reason,
always state the case in full, e.g. dollar call Swiss franc
put or vice versa.
What does a ‘live price’ mean? The price of an
option is obviously dependent on the spot price in the market.
As an option trader needs to delta hedge the option straight
away, the spot at which the trader can hedge is the rate the
trader uses to price the option. If a price is being quoted
live it means that the person asking for the price will be quoted
a premium price for the option and the option trader will take
the risk that spot moves during the transaction. The alternative
to dealing live is to deal ‘with delta’. This
means that the person asking the price will deal the delta hedge
with the option trader as well as the option.
How is the premium normally quoted? Normally, the premium is
quoted as a percentage of the base currency amount of the option.
However, in the interbank market, it is normally quoted as pips
per currency amount of the option. For example, if the option
is a dollar/ Swiss franc option, the premium can be quoted in
the following ways:
- Percentage of the dollar amount of the
option
- Percentage of the Swiss franc amount
of the option
- Swiss franc pips per dollar amount of
the option
- Dollar pips per Swiss franc amount of
the option
If the option were being dealt in a round
amount of dollars, e.g. ten million dollars, then either 1)
or 3) would be the usual quote. If 2) or 4) were required, however,
the Swiss franc amount of the option is found by multiplying
the dollar amount by the strike of the option.
Parties
Involved
There are two parities involved in currency
options: the option buyer and the option seller. The following
grid outlines a risk profile for each:
» The option buyer has the right to demand fulfilment
of the currency option contract, as they adcan
exercise the option and they pay a premium for that right
» The option seller (or writer) grants the right and receives
a premium for accepting the trobligation
to fulfil the currency option contract, if the buyer demands
|
Financial Risk |
Profit Potential |
| Option Buyer |
Limited to premium paid |
Unlimited |
| Option Seller |
Unlimited |
Limited to premium earned |
|
