Forex Options Market Overview
The forex options market ongoing as an over-the-counter (OTC) fiscal vehicle for large banks, fiscal institutions and large global corporations to hedge against foreign currency exposure. Like the forex spot market, the forex options market is thorough an “interbank” market. But, with the overabundance of real-time fiscal data and forex option trading software unfilled to most investors owing to 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 touchtone phone or online forex trading platforms.
Forex option trading has emerged as an different 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 apply.
Most forex options trading is conducted via touchtone phone as there are only a few forex brokers donation online forex option trading platforms.
Forex Option Defined – A forex option is a fiscal currency contract giving the forex option buyer the right, but not the obligation, to hold or sell a specific forex spot contract (the underlying) at a specific price (the strike price) on or before a specific date (the end 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 end, or he or she can choose to hold the foreign currency options contract until end and implementation 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 fiscal obligation of the foreign currency option buyer is to pay the premium to the seller up front when the foreign currency option is initially bought. Once the premium is paid, the foreign currency option holder has no other fiscal obligation (no margin is required) until the foreign currency option is either offset or expires.
On the end date, the call buyer can implementation his or her right to buy the underlying foreign currency spot position at the foreign currency option’s strike price, and a place holder can implementation 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 as a substitution for are offset in the market before end.
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 place 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 additional obligation to the other party.
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 doable 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 at once 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 go 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. But, if the markets go in an unfavorable direction for the foreign currency options seller, the seller may have to post bonus funds to his or her foreign currency trading account to keep the weigh 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 end, or the seller can choose to hold the foreign currency option contract until end. If the foreign currency options seller holds the contract until end, 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 (maintenance 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 place buyer there is a place 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 chat call option gives the foreign chat options buyer the right, but not the obligation, to hold a specific foreign chat spot contract (the underlying) at a specific price (the strike price) on or before a specific date (the end date). The amount the foreign chat option buyer pays to the foreign chat option seller for the foreign chat option contract rights is called the option “premium.”
Please note that “puts” and “calls” are separate foreign chat options contracts and are NOT the opposite side of the same transaction. For every foreign chat place buyer there is a foreign chat place seller, and for every foreign chat call buyer there is a foreign chat call seller. The foreign chat options buyer pays a premium to the foreign chat options seller in every option transaction.
The Forex Place Option – A foreign chat place option gives the foreign chat options buyer the right, but not the obligation, to sell a specific foreign chat spot contract (the underlying) at a specific price (the strike price) on or before a specific date (the end date). The amount the foreign chat option buyer pays to the foreign chat option seller for the foreign chat option contract rights is called the option “premium.”
Please note that “puts” and “calls” are separate foreign chat options contracts and are NOT the opposite side of the same transaction. For every foreign chat place buyer there is a foreign chat place seller, and for every foreign chat call buyer there is a foreign chat call seller. The foreign chat options buyer pays a premium to the foreign chat options seller in every option transaction.
Plain Vanilla Forex Options – Plain vanilla options generally refer to ordinary place and call option contracts traded owing to an chat (but, in the case of forex option trading, plain vanilla options would refer to the ordinary, generic forex option contracts that are traded owing to an over-the-counter (OTC) forex options dealer or clearinghouse). In simplest terms, vanilla forex options would be defined as the buying or promotion of a ordinary forex call option contract or a forex place option contract.
Exotic Forex Options – To be with you what makes an exotic forex option “exotic,” you must first be with you what makes a forex option “non-vanilla.” Plain vanilla forex options have a definitive end organize, payout organize 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 vital to note that exotic options, since they are often tailored to a specific’s shareholder’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 thorough “out-of-the-money,” an FX option having intrinsic value is thorough “in-the-money,” and an FX option with a strike price at, or very close to, the underlying FX spot rate is thorough “at-the-money.”
The extrinsic value of an FX option is frequently 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 counting, but not top secret to, the volatility of the two spot currencies caught up, the time left until end, the riskless interest rate of both currencies, the spot price of both currencies and the strike price of the FX option. It is vital to note that the extrinsic value of FX options erodes as its end nears. An FX option with 60 days left to end will be worth more than the same FX option that has only 30 days left to end. Because there is more time for the underlying FX spot price to possibly go in a favorable direction, FX options sellers demand (and FX options buyers are keen to pay) a larger premium for the extra amount of time.
Volatility – Volatility is thorough the most vital 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 place options.
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 end 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 implementation 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 insightful to a change in the underlying rate.
John Nobile – Senior Account Executive
CFOS/FX – Online Forex Spot and Options Brokerage
Author: John Nobile
Article Source: EzineArticles.com
Provided by: Wordpress plugin Guest Blogger