1. The forex options market started as an over-the-counter (OTC) financial vehicle for large banks,
financial institutions and large international corporations to hedge against foreign currency
exposure. Like the forex spot market, the forex options market is considered an "interbank"
market. However, with the plethora of real-time financial data and forex option trading software
available to most investors through the internet, today's forex option market now includes an
increasingly large number of individuals and corporations who are speculating and/or hedging
foreign currency exposure via telephone or online forex trading platforms.
Forex option trading has emerged as an alternative investment vehicle for many traders and
investors. As an investment tool, forex option trading provides both large and small investors with
greater flexibility when determining the appropriate forex trading and hedging strategies to
implement.
Most forex options trading is conducted via telephone as there are only a few forex brokers
offering online forex option trading platforms.
Forex Option Defined - A forex option is a financial currency contract giving the forex option buyer
the right, but not the obligation, to purchase or sell a specific forex spot contract (the underlying) at
a specific price (the strike price) on or before a specific date (the expiration date). The amount the
forex option buyer pays to the forex option seller for the forex option contract rights is called the
forex option "premium."
The Forex Option Buyer - The buyer, or holder, of a foreign currency option has the choice to
either sell the foreign currency option contract prior to expiration, or he or she can choose to hold
the foreign currency options contract until expiration and exercise his or her right to take a position
in the underlying spot foreign currency. The act of exercising the foreign currency option and
taking the subsequent underlying position in the foreign currency spot market is known as
"assignment" or being "assigned" a spot position.
The only initial financial obligation of the foreign currency option buyer is to pay the premium to the
seller up front when the foreign currency option is initially purchased. Once the premium is paid,
the foreign currency option holder has no other financial obligation (no margin is required) until the
foreign currency option is either offset or expires.
On the expiration date, the call buyer can exercise his or her right to buy the underlying foreign
currency spot position at the foreign currency option's strike price, and a put holder can exercise
his or her right to sell the underlying foreign currency spot position at the foreign currency option's
strike price. Most foreign currency options are not exercised by the buyer, but instead are offset in
the market before expiration.
Foreign currency options expires worthless if, at the time the foreign currency option expires, the
strike price is "out-of-the-money." In simplest terms, a foreign currency option is "out-of-the-
money" if the underlying foreign currency spot price is lower than a foreign currency call option's
strike price, or the underlying foreign currency spot price is higher than a put option's strike price.
Once a foreign currency option has expired worthless, the foreign currency option contract itself
expires and neither the buyer nor the seller have any further obligation to the other party.
2. The Forex Option Seller - The foreign currency option seller may also be called the "writer" or
"grantor" of a foreign currency option contract. The seller of a foreign currency option is
contractually obligated to take the opposite underlying foreign currency spot position if the buyer
exercises his right. In return for the premium paid by the buyer, the seller assumes the risk of
taking a possible adverse position at a later point in time in the foreign currency spot market.
Initially, the foreign currency option seller collects the premium paid by the foreign currency option
buyer (the buyer's funds will immediately be transferred into the seller's foreign currency trading
account). The foreign currency option seller must have the funds in his or her account to cover the
initial margin requirement. If the markets move in a favorable direction for the seller, the seller will
not have to post any more funds for his foreign currency options other than the initial margin
requirement. However, if the markets move in an unfavorable direction for the foreign currency
options seller, the seller may have to post additional funds to his or her foreign currency trading
account to keep the balance in the foreign currency trading account above the maintenance
margin requirement.
Just like the buyer, the foreign currency option seller has the choice to either offset (buy back) the
foreign currency option contract in the options market prior to expiration, or the seller can choose
to hold the foreign currency option contract until expiration. If the foreign currency options seller
holds the contract until expiration, one of two scenarios will occur: (1) the seller will take the
opposite underlying foreign currency spot position if the buyer exercises the option or (2) the seller
will simply let the foreign currency option expire worthless (keeping the entire premium) if the
strike price is out-of-the-money.
Please note that "puts" and "calls" are separate foreign currency options contracts and are NOT
the opposite side of the same transaction. For every put buyer there is a put seller, and for every
call buyer there is a call seller. The foreign currency options buyer pays a premium to the foreign
currency options seller in every option transaction.
Forex Call Option - A foreign exchange call option gives the foreign exchange options buyer the
right, but not the obligation, to purchase a specific foreign exchange spot contract (the underlying)
at a specific price (the strike price) on or before a specific date (the expiration date). The amount
the foreign exchange option buyer pays to the foreign exchange option seller for the foreign
exchange option contract rights is called the option "premium."
Please note that "puts" and "calls" are separate foreign exchange options contracts and are NOT
the opposite side of the same transaction. For every foreign exchange put buyer there is a foreign
exchange put seller, and for every foreign exchange call buyer there is a foreign exchange call
seller. The foreign exchange options buyer pays a premium to the foreign exchange options seller
in every option transaction.
The Forex Put Option - A foreign exchange put option gives the foreign exchange options buyer
the right, but not the obligation, to sell a specific foreign exchange spot contract (the underlying) at
a specific price (the strike price) on or before a specific date (the expiration date). The amount the
foreign exchange option buyer pays to the foreign exchange option seller for the foreign exchange
option contract rights is called the option "premium."
3. Please note that "puts" and "calls" are separate foreign exchange options contracts and are NOT
the opposite side of the same transaction. For every foreign exchange put buyer there is a foreign
exchange put seller, and for every foreign exchange call buyer there is a foreign exchange call
seller. The foreign exchange options buyer pays a premium to the foreign exchange options seller
in every option transaction.
Plain Vanilla Forex Options - Plain vanilla options generally refer to standard put and call option
contracts traded through an exchange (however, in the case of forex option trading, plain vanilla
options would refer to the standard, generic forex option contracts that are traded through an over-
the-counter (OTC) forex options dealer or clearinghouse). In simplest terms, vanilla forex options
would be defined as the buying or selling of a standard forex call option contract or a forex put
option contract.
Exotic Forex Options - To understand what makes an exotic forex option "exotic," you must first
understand what makes a forex option "non-vanilla." Plain vanilla forex options have a definitive
expiration structure, payout structure and payout amount. Exotic forex option contracts may have
a change in one or all of the above features of a vanilla forex option. It is important to note that
exotic options, since they are often tailored to a specific's investor's needs by an exotic forex
options broker, are generally not very liquid, if at all.
Intrinsic & Extrinsic Value - The price of an FX option is calculated into two separate parts,
the intrinsic value and the extrinsic (time) value.
The intrinsic value of an FX option is defined as the difference between the strike price and the
underlying FX spot contract rate (American Style Options) or the FX forward rate (European Style
Options). The intrinsic value represents the actual value of the FX option if exercised. Please
note that the intrinsic value must be zero (0) or above - if an FX option has no intrinsic value, then
the FX option is simply referred to as having no (or zero) intrinsic value (the intrinsic value is never
represented as a negative number). An FX option with no intrinsic value is considered "out-of-the-
money," an FX option having intrinsic value is considered "in-the-money," and an FX option with a
strike price at, or very close to, the underlying FX spot rate is considered "at-the-money."
The extrinsic value of an FX option is commonly referred to as the "time" value and is defined as
the value of an FX option beyond the intrinsic value. A number of factors contribute to the
calculation of the extrinsic value including, but not limited to, the volatility of the two spot
currencies involved, the time left until expiration, the riskless interest rate of both currencies, the
spot price of both currencies and the strike price of the FX option. It is important to note that the
extrinsic value of FX options erodes as its expiration nears. An FX option with 60 days left to
expiration will be worth more than the same FX option that has only 30 days left to expiration.
Because there is more time for the underlying FX spot price to possibly move in a favorable
direction, FX options sellers demand (and FX options buyers are willing to pay) a larger premium
for the extra amount of time.
Volatility - Volatility is considered the most important factor when pricing forex options and it
measures movements in the price of the underlying. High volatility increases the probability that
the forex option could expire in-the-money and increases the risk to the forex option seller who, in
turn, can demand a larger premium. An increase in volatility causes an increase in the price of
both call and put options.
4. Delta - The delta of a forex option is defined as the change in price of a forex option relative to a
change in the underlying forex spot rate. A change in a forex option's delta can be influenced by a
change in the underlying forex spot rate, a change in volatility, a change in the riskless interest
rate of the underlying spot currencies or simply by the passage of time (nearing of the expiration
date).
The delta must always be calculated in a range of zero to one (0-1.0). Generally, the delta of a
deep out-of-the-money forex option will be closer to zero, the delta of an at-the-money forex option
will be near .5 (the probability of exercise is near 50%) and the delta of deep in-the-money forex
options will be closer to 1.0. In simplest terms, the closer a forex option's strike price is relative to
the underlying spot forex rate, the higher the delta because it is more sensitive to a change in the
underlying rate.
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