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OPTIONS TRADING

FX Options: The Elephant in the Room

How to Generate Significant Returns from Anomalies and Biases in the FX Option Market

FX Options, The Elephant in the Room, How to, Generate, Significant Returns, Anomalies, Biases, FX Option Market, Options Trading, fx trader

Premium vs Payout

The phrase ‘the elephant in the room’ is usually used to refer to a fact which is glaringly obvious once pointed out, but to which people have been oblivious for some time.  There is an elephant in the FX options room.

FX options are a huge market.  The latest Bank of International Settlements survey in 2013 found that there was over 300 billion USD worth of flow every trading day.   Spreads are tiny and liquidity is large.  So how can there possibly be any systematic bias or predictable pattern which has not already been traded away?

And yet, there is.  If one were presented with a financial instrument which on average pays back only half of what it cost, one would call it either a bad deal (if bought) or an opportunity (if sold).  Or if one were presented with an insurance contract which on average paid back 50% more than its premium, it would be highly desirable to buy, but not good to sell.  This situation is exactly what we find with some FX options.

Let us take a look at the data.  Below, in Figure 1 and Figure 2, we have plotted the average payout to FX put and call options1, divided by the average premium, throughout history since the start of the market.  The 34 most liquid currencies were used.  The options were the most liquid type, At-the-Money-Forward puts and calls.  Additionally, we included trading costs.

If options were perfectly ‘fairly’ priced, we would expect to see that all of these data points hovered at about 100%.  If, more realistically, we expect trading desks to make a profit, we might anticipate that they would all be a little less than 100%.  But that is not what we see at all.

FX Options, The Elephant in the Room, How to, Generate, Significant Returns, Anomalies, Biases, FX Option Market,  Forex Strategy, fx traderFigure 1: Payout-to-premium ratio for ATMF call options          Source: Bloomberg and Commerzbank

FX Options, The Elephant in the Room, How to, Generate, Significant Returns, Anomalies, Biases, FX Option Market,  Forex Strategy, fx traderFigure 2: Payout-to-premium ratio for ATMF put options          Source: Bloomberg and Commerzbank


1 Note that these are puts and calls on the exchange rate, ie, on the base currency

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