options trading forex options primer

The popularity of options since the turn of the Millennium has been nothing short of impressive. Foreign Exchange is the largest, most liquid market globally. According to the Bank of International Settlements, over 3 Trillion USD of volume is transacted daily.  And estimates suggest the Options market generates about 300 Billion USD per day. As this market has quickly matured, there have been some marked innovations and efficiencies with products, liquidity, price transparency and execution platforms. With the credit crisis related volatility, more and more corporations and investors are using options as a much safer and responsible means of hedging/speculating. With each passing day, participation in Foreign Exchange Options, has moved from choice to necessity.

Options are derivative instruments whose values are derived from underlying interests or assets.  Simplistically, options provide the buyer the right –not obligation- to buy or sell said underlying interests. For instance, when the purchaser buys a call contract on the Euro Dollar, it entitles him to buy Euros and sell US Dollars in the spot market at a predetermined price and maturity. Equally, the put purchase allows the buyer of the option the right to sell Euros against US Dollars at a set strike price and maturity. Quid pro quo, of course.  A premium is exchanged for this right. The calculation of premium is determined by various input factors as well as other market conditions which shall be discussed in subsequent articles. This is merely intended as a rudimentary, yet colorful, primer on options.

Apart from the payment of premium, there is very little downside to using options. These premiums are expressed as a small percentage of notional, allowing for significant leverage in the market. In a world where capital has become increasingly scarce, options are clearly the sensible solution. Sellers of options with deliverables are able to monetize much of their FX exposures by applying premiums earned to gains/losses of their positions. The OTC (Over the Counter) market allows buyers and sellers to custom tailor each contract to their preference: currency pair, notional, maturity and strike price.

For speculators in volatile markets, options eliminate the potential of being stopped out on positions. The slippage on spot stop losses can be very costly. Consequently, it is no wonder that the largest institutional clients of FX Option Desks tend to be their Spot traders. That says a lot. In many instances, market views are sound and correct. That being said, however, market noise and illiquidity are often what trigger stops.  When both hedgers and speculators avoid the disruption and pain of costly stops they are able to focus on their core business/trading strategies.

The following depicts the simple profit-loss characteristics in both puts and calls.  The Vertical axis represents PNL and the Horizontal represents underlying asset price.

1 options trading forex options primer profit lost characteristics

As can be seen below, when buying an option, the profit potential is unlimited whereas the potential loss is limited to the amount paid for the premium. Selling an option gives you a premium up front, but the premium is also the maximum profit you can take. So, if you sell an option, the profit/loss scenario is the opposite of when buying one. (Limited gain, unlimited loss potential).

In the vanilla options world, structures and strategies involve calls, puts or a combination of both. The following depicts some simple vanilla structures which are used quite frequently.  Each strategy can be tailored to suit views, risk tolerance, budget and overall objectives.

options trading forex options primer vanilla options

options trading forex options primer vanilla options

As mentioned earlier, the depth and maturity of this market have brought significant enhancements. Exotic options, which shall be discussed in the near future, have allowed for more cutting edge risk management and speculative strategies. From a liquidity perspective, electronic platforms now provide impressive access, transparency and execution into the home offices of millions of retail traders.

The FX Options market has enjoyed a robust annual growth rate of 20%. Options are here to stay and are clearly the way of the future.

Ashif F. Jiwani