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 cash 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 net, today's forex option market now includes an increasingly large number of individuals and corporations who are speculating and/or hedging foreign cash exposure by telephone or online forex trading platforms.
Forex option trading has emerged as an alternative investment vehicle for lots of traders and investors. As an investment gizmo, 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 by telephone as there's only a few forex brokers offering online forex option trading platforms.
Forex Option Defined - A forex option is a financial cash 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 cash option has the choice to either sell the foreign cash option contract prior to expiration, or he or we can pick to hold the foreign cash options contract until expiration and exercise his or her right to take a position in the underlying spot foreign funds. The act of exercising the foreign cash option and taking the subsequent underlying position in the foreign cash spot market is known as "assignment" or being "assigned" a spot position.
The only initial financial obligation of the foreign cash option buyer is to pay the premium to the seller up front when the foreign cash option is initially purchased. three times the premium is paid, the foreign cash option holder has no other financial obligation (no margin is required) until the foreign cash option is either offset or expires.
On the expiration date, the call buyer can exercise his or her right to buy the underlying foreign cash spot position at the foreign cash option's strike price, and a put holder can exercise his or her right to sell the underlying foreign cash spot position at the foreign cash option's strike price. Most foreign cash options aren't exercised by the buyer, but instead are offset in the market before expiration.
Foreign cash options expires worthless if, at the time the foreign cash option expires, the strike price is "out-of-the-money." In simplest terms, a foreign cash option is "out-of-the-money" if the underlying foreign cash spot price is lower than a foreign cash call option's strike price, or the underlying foreign cash spot price is higher than a put option's strike price. three times a foreign cash option has expired worthless, the foreign cash option contract itself expires and neither the buyer nor the seller have any further obligation to the other party.
Initially, the foreign cash option seller collects the premium paid by the foreign cash option buyer (the buyer's cash will immediately be transferred in to the seller's foreign cash trading account). The foreign cash option seller must have the cash in his or her account to cover the initial margin requirement. If the markets move in a favorable direction for the seller, the seller won't have to post any more cash for his foreign cash options other than the initial margin requirement. However, if the markets move in an unfavorable direction for the foreign cash options seller, the seller may have to post additional cash to his or her foreign cash trading account to keep the balance in the foreign cash trading account above the maintenance margin requirement.
The Forex Option Seller - The foreign cash option seller may also be called the "writer" or "grantor" of a foreign cash option contract. The seller of a foreign cash option is contractually obligated to take the opposite underlying foreign cash 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 cash spot market.
note that "puts" and "calls" are separate foreign cash options contracts and aren't 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 cash options buyer pays a premium to the foreign cash options seller in every option transaction.
like the buyer, the foreign cash option seller has the choice to either offset (buy back) the foreign cash option contract in the options market prior to expiration, or the seller can pick to hold the foreign cash option contract until expiration. If the foreign cash options seller holds the contract until expiration, one of two scenarios will occur: (1) the seller will take the opposite underlying foreign cash spot position if the buyer exercises the option or (2) the seller will simply let the foreign cash option expire worthless (keeping the entire premium) if the strike price is out-of-the-money.
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."
note that "puts" and "calls" are separate foreign exchange options contracts and aren't 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."
note that "puts" and "calls" are separate foreign exchange options contracts and aren't 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.
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 we are often tailored to a specific's investor's needs by an exotic forex options broker, are generally not fluid, if at all.
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.
Intrinsic & Extrinsic Value - The price of an FX option is calculated in to 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. 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 close to, the underlying FX spot rate is considered "at-the-money."
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.
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. some 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 over 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.
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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