Primer on FX Options

Types of FX Options
There are two types of FX options – calls and puts. Buying a call option gives you the right to buy a currency pair while buying a put option gives you the right to sell a currency pair on the expiry date. Selling a call option involves taking on an obligation to sell at a pre-agreed price on the expiry date while selling a put option involves taking on an obligation to buy at a pre-agreed price on the expiry date in exchange for receiving a premium.

We shall use an example involving EURUSD call and put options below to illustrate this:

Buying FX Options
Typically, traders who wish to place a directional bet on a currency pair would buy OTM calls or puts. As OTM options are much cheaper and as a result offer the most leverage, it gives the most bang for buck especially when one is trying to trade strategies that offer asymmetrical returns. OTM options however are most prone to time decay (meaning the more time passes without the spot prices moving in favour of the option the more acute the loss of value of the option).

At times, traders might wish to buy ATM options due to their sensitivity to volatility and price changes in the underlying. Due to their higher deltas (sensitivity to spot price move), they are also relatively more likely to expire in-the money. The flip side is that ATM options cost more than OTM options and therefore can lead to higher loss of premium if the option expires worthless.

ITM options have high intrinsic value (forward price - strike for calls and strike – forward price for puts) and often work like a proxy spot position. These options are usually much more expensive and thus offer little leverage. In addition, the total premium loss would be much larger should the option expire worthless. In short, the optionality in an ITM option is limited and hence it tends to be less popular.

Another way good traders would try to reduce the premium paid is via trading option strategies to implement their views. Some common strategies include call spreads (Buy call, Sell call), put spreads (Buy put, Sell put), collar strategies (Long stock, Buy put, Sell call) and risk reversals (Sell put/Buy call or Sell call/Buy put)

Selling FX Options
Traders can generate income by selling FX options in exchange for a premium. As an option seller, you are receiving the premium to protect the option buyer from market moves. The maximum gain from selling options is the premium received while the losses can be unlimited.

Why do traders sell FX Options?
If selling FX options can lead to unlimited losses, why would anyone sell them? As the value of options comprise of volatility, time decay and moneyness of the option, traders can take advantage of temporary spikes in volatility to sell FX options to express their view on the market. Premium received can be measured in basis points to give you a fairer indication of the amount of premium you receive during different time periods.

Selling puts
If you are bullish on USDJPY and think that the pair is unlikely to fall below 136 in the next month (and you are prepared to buy it at 136 even if it gets there), one way to express this view is to sell 1 month puts at the strike of 136 for some premium. If USDPY stays above 136, you do not have any obligations at expiry but if USDJPY falls below 136, you would be long USDJPY from 136.

Selling calls
On the contrary, if you are bearish on USDJPY and think the pair is unlikely to rise above 140 in the next month (and you are prepared to sell at 140 even if it gets there), you can sell 1 month calls at strike 140 for some premium. If USDJPY stays below 140, you do not have any obligations but if USDJPY rises above 140, you will be short USDJPY from 140.

Key differences between FX options and Equity options
1. FX options are traded over-the-counter (OTC) instead of an exchange. As these products are traded OTC, the variables like the size, strike price, and tenor are customizable. You can choose your own size, expiry date and strike price instead of adhering to standardized ones you would typically find in an exchange traded option like equity options.

2. FX options are European style options. This means that these options can only be exercised on the expiry date as compared to any time before expiry in American options.

3. When you exercise an FX option, the resulting position is a FX margin position instead of a position required to be fully funded by cash. For example, a 100,000 USDJPY call option expiring in-the-money (ITM) will result in a long 100,000 USDJPY position that utilizes way less margin than 100,000 USD. If initial margin is 5%, then 5,000 USD is required to receive this position at the strike price in addition to the position P&L.

Key advantages of trading FX options
1. The maximum loss from buying FX options is the premium paid. Buying FX options to express your view will not lead to margin calls due to mark-to-market losses.

2. Selling FX options in the right conditions can lead to a steady income (premium) stream to supplement your portfolio returns. Typically traders can take advantage of a interim spike in volatility in a deeply liquid market that trades 24 hours a day for 5 days a week to sell FX options to maximize their returns.

3. Options are often used by FX traders as proxy take profit (Sell call against long/Sell put against short) or stop loss orders (Buy put against long/Sell call against short) for their spot trading

Key risks of trading FX options
1. There is a potential of unlimited loss when selling FX options due to the high leverage factor.

2. There is a risk of using FX options as a means to take profit or enter into a position as the option might be in-the-money before expiry and turn out-of-the-money at expiry. Without the option, you might have taken profit or entered into a position via a spot order otherwise.

3. Buying far OTM FX options frequently can lead to a low probability of success and too much premium loss due to time decay.