Introduction to Currency Options (Option on Spot, Futures & Futures Style Options)

In finance, a foreign exchange option (Commonly shortened to just FX option or currency option) is a derivative financial instrument that gives the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. See Foreign exchange derivative.

The foreign exchange options market is the deepest, largest and most liquid market for options of any kind. Most trading is over the counter (OTC) and is lightly regulated, but a fraction is traded on exchanges like the International Securities Exchange, Philadelphia Stock Exchange, or the Chicago Mercantile Exchange for options on futures contracts. The global market for exchange-traded currency options was notionally valued by the Bank for International Settlements at $578.3 trillion in 2019.

Terms

Call option: The right to buy an asset at a fixed date and price.

Put option: The right to sell an asset at a fixed date and price.

Foreign exchange option: The right to sell money in one currency and buy money in another currency at a fixed date and rate.

Strike price: The asset price at which the investor can exercise an option.

Spot price: The price of the asset at the time of the trade.

Forward price: The price of the asset for delivery at a future time.

Notional: The amount of each currency that the option allows the investor to sell or buy.

Ratio of notionals: The strike, not the current spot or forward.

Numéraire: The currency in which an asset is valued.

Non-linear payoff: The payoff for a straightforward FX option is linear in the underlying currency, denominating the payout in a given numéraire.

Change of numéraire: The implied volatility of an FX option depends on the numéraire of the purchaser, again because of the non-linearity of xà 1/x.

In the money for a put option, this is when the current price is less than the strike price, and would thus generate a profit were it exercised; for a call option the situation is inverted.

A currency option (also known as a forex option) is a contract that gives the buyer the right, but not the obligation, to buy or sell a certain currency at a specified exchange rate on or before a specified date. For this right, a premium is paid to the seller.

Currency options are one of the most common ways for corporations, individuals or financial institutions to hedge against adverse movements in exchange rates.

Investors can hedge against foreign currency risk by purchasing a currency put or call. Currency options are derivatives based on underlying currency pairs. Trading currency options involves a wide variety of strategies available for use in forex markets. The strategy a trader may employ depends largely on the kind of option they choose and the broker or platform through which it is offered. The characteristics of options in decentralized forex markets vary much more widely than options in the more centralized exchanges of stock and futures markets.

Traders like to use currency options trading for several reasons. They have a limit to their downside risk and may lose only the premium they paid to buy the options, but they have unlimited upside potential. Some traders will use FX options trading to hedge open positions they may hold in the forex cash market. As opposed to a futures market, the cash market, also called the physical and spot market, has the immediate settlement of transactions involving commodities and securities. Traders also like forex options trading because it gives them a chance to trade and profit on the prediction of the market’s direction based on economic, political, or other news.

Option on Spot

The term spot price is not limited to options or stocks you can use it when referring to the current market price of any security. It is most commonly used with securities which besides the spot market also have futures or forward markets, such as commodities, currencies or interest rates.

For instance, you can hear about the “gold spot price” as opposed to gold futures prices, or you can “buy euros on the spot market” as opposed to the forward market. Generally, spot price is the price for immediate delivery or settlement (in practice, immediate typically means settled within a very few, like 1-3, days), while a futures or forward price, although agreed now, is for settlement at a given date in the future (e.g. one month or even one year from now).

Futures & Futures Style Options

An option on a futures contract gives the holder the right, but not the obligation, to buy or sell a specific futures contract at a strike price on or before the option’s expiration date. These work similarly to stock options, but differ in that the underlying security is a futures contract.

Most options on futures, such as index options, are cash settled. They also tend to be European-style options, which means that these options cannot be exercised early.

A proposed contract to replace many traditional options on futures contracts. Unlike traditional options, the buyer of a futures-style option does not prepay the premium. Buyers and sellers post margin as in a futures contract, and the option premium is marked to the market daily. Valuation differs from traditional futures options primarily in the analysis of the timing of cash flows associated with the buyer’s nonpayment of an upfront premium.

An option on a futures contract is very similar to a stock option in that it gives the buyer the right, but not obligation, to buy or sell the underlying asset, while creating a potential obligation for the seller of the option to buy or sell the underlying asset if the buyer so desires by exercising that option. That means the option on a futures contract, or futures option, is a derivative security of a derivative security. But the pricing and contract specifications of these options does not necessarily add leverage on top of leverage.

An option on an S&P 500 futures contract, therefore, can be thought of as a second derivative of the S&P 500 index since the futures are themselves derivatives of the index. As such, there are more variables to consider as both the option and the futures contract have expiration dates and their own supply and demand profiles. Time decay (also known as theta), works on options futures the same as options on other securities, so traders must account for this dynamic.

For call options on futures, the holder of the option would enter into the long side of the contract and would buy the underlying asset at the option’s strike price. For put options, the holder of the option would enter into the short side of the contract and would sell the underlying asset at the option’s strike price.

For calls:

ITM: underlying price > strike price

OTM: underlying price < strike price

For puts it’s the opposite:

ITM: underlying price < strike price

OTM: underlying price > strike price

For both calls and puts:

ATM: underlying price = strike price