A currency option is a contract between a buyer and a seller that gives the buyer the right, but not the obligation, to trade a specific amount of currency at a predetermined price and within a predetermined period of time, regardless of the market price of the currency; and gives the seller, or writer, the obligation to deliver the currency under the predetermined terms, if and when the buyer wants to exercise the option.
Currency options are unique trading instruments, equally fit for speculation and hedging. Options allow for a comprehensive customization of each individual strategy, a quality of vital importance for the sophisticated investor. More factors affect the option price relative to the prices of other foreign currency instruments. Unlike spot or forwards, both high and low volatility may generate a profit in the options market. For some, options are a cheaper vehicle for currency trading. For others, options mean added security and exact stop-loss order execution.
Currency options constitute the fastest-growing segment of the foreign exchange market. As of April 1998, options represented 5 percent of the foreign exchange market. (See Figure 3.1) The biggest options trading center is the United States, followed by the United Kingdom and Japan. Options prices are based on, or derived from, the cash instruments. Therefore, an option is a derivative instrument. Options are usually mentioned vis-a-vis insurance and hedging strategies. Often, however, traders have misconceptions regarding both the difficulty and simplicity of using options.
There are also misconceptions regarding the capabilities of options. In the currency markets, options are available on either cash or futures. It follows, then, that they are traded either over-the-counter (OTC) or on the
centralized futures markets. The majority of currency options, around 81 percent, are traded overthe-counter. (See Figure 3.3) The over-the-counter market is similar to the spot or swap market. Corporations may call banks and banks will trade with each other either directly or in the brokers’ market. This type of dealing allows for maximum flexibility: any amount, any currency, any odd expiration date, any time. The currency amounts may be even or odd. The amounts may be quoted in either U.S. dollars or foreign currencies.
Any currency may be traded as an option, not only the ones available as futures contracts. Therefore, traders may quote on any exotic currency, as required, including any cross currencies.
The expiration date may be quoted anywhere from several hours to several years, although the bulk of dates are concentrated around the even dates—one week, one month, two months, and so on. The cash market never closes, so options may be traded literally around the clock.
Trading an option on currency futures will entitle the buyer to the right, but not the obligation, to take physical possession of the currency future. Unlike the currency futures, buying currency options does not require an initiation margin. The option premium, or price, paid by the buyer to the seller, or writer, reflects the buyer’s total risk.
However, upon taking physical possession of the currency future by exercising the option, a trader will have to deposit a margin.
Seven major factors have an impact on the option price:
- Price of the currency.
- Strike (exercise) price.
- Volatility of the currency.
- Expiration date.
- Interest rate differential.
- Call or put.
- American or European option style.
The currency price is the central building block, as all the other factors are compared and analyzed against it. It is the currency price behavior that both generates the need for options and impacts on the profitability of options.
The impact of the currency price on the option premium is measured by delta, the first of the Greek letters used to describe aspects of the theoretical pricing models in this discussion of factors determining the option price.
Delta, or commonly A, is the first derivative of the option-pricing model Delta may be viewed in three respects:
- as the change of the currency option price relative to a change in the currency price. For instance, an option with a delta of 0.5 is expected to move at one half the rate of change of the currency price. Therefore, if the price of a currency goes up 10 percent, then the price of an option on that particular currency is expected to rise by 5 percent.
- as the hedge ratio between the option contracts and the currency futures contracts necessary to establish a neutral hedge. Therefore, an option with a delta of 0.5 will need two option contracts for each of the currency futures contracts.
- as the theoretical or equivalent share position. In this case, delta is the number of currency futures contracts by which a call buyer is long or a put buyer is short. If we use the same example of the delta of 5, then the buyer of the put option is short half a currency futures contract.
Traders may be unable to secure prices in the spot, forward outright, or futures market, temporarily leaving the position delta unhedged. In order to avoid the high cost of hedging and the risk of unusually high volatility, traders may hedge their original options positions with other options. This method of risk neutralization is called gamma or vega hedging.
Gamma (Г) is also known as the curvature of the option. It is the second derivative of the option-pricing model and is the rate of change of an option’s delta, or the sensitivity of the delta. For instance, an option with delta = 0.5 and gamma = 0.05 is expected to have a delta = 0.55 if the currency rises by 1 point, or a delta = 0.45 if the currency decreases by 1 point.
Gamma ranges between 0 percent and 100 percent. The higher the gamma, the higher the sensitivity of the delta. It may therefore be useful to think of gamma as the acceleration of the option relative to the movement of the currency.
Vega gauges volatility impact on the option premium. Vega (<;) is the sensitivity of the theoretical value of an option to a change in volatility. For instance, a vega of 0.2 will generate a 0.2 percent increase in the premium for each percentage increase in the volatility estimate, and a 0.2 percent decrease in the premium for each percentage decrease in the volatility estimate.
The option is traded for a predetermined period of time, and when this time expires, there is a delivery date known as the expiration date. A buyer who intends to exercise the option must inform the writer on or before expiration. The buyer’s failure to inform the writer about exercising the option frees the writer of any legal obligation. An option cannot be exercised past the expiration date.
Theta (T), also known as time decay, occurs as the very slow or nonexistent movement of the currency triggers losses in the option’s theoretical value. For instance, a theta of 0.02 will generate a loss of 0.02 in the premium for each day that the currency price is flat. Intrinsic value is not affected by time, but extrinsic value is. Time decay accelerates as the option approaches expiration, since the number of possible outcomes is continuously reduced as the time passes.
Time has its maximum impact on at-the-money options and its minimum effect on in-the-money options. Time’s effect on out-of-the-money options occurs somewhere within that range. Bid-offer spreads in the market may make it too expensive to sell the option and trade forward out rights. If the option shifts deeply into the money, the interest rate differential gained by early exercise may exceed the value of the option. If the option amount is small or the expiration is close and the option value only consists of the intrinsic value, it may be better to use the early exercise. Due to the complexity of its determining factors, option pricing is difficult. In the absence of option pricing models, option trading is nothing but inefficient gambling. The one idea to make option pricing is that the option of buying the domestic currency with a foreign currency at a certain price x is equivalent to the option of selling the foreign currency with the domestic currency at the same price x. Therefore, the call option in the domestic currency becomes the put option in the other, and vice versa.