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Beginner Level : Chapter 2

Agenda

  • FX Options Expire
  • European and American Style Options
  • Bid and Ask Prices
  • FX Call and Put Contract Specifications
  • In the Money, At the Money or Out of the Money
  • Intrinsic and Time Value
  • Payoffs and Cash Settlements

FX Options Expire

For a given currency pair, dealers quote prices for options that have different strike prices and expiration dates.

A dealer’s price quotes sort options by their strike prices and expiry months and years.

FX options expiry are the prerogative of the dealer. Typically, options expire in the third week of the month or the end of the month. Each dealer handles expiration differently. For the purpose of the Options University, we’ll presume expiration is the third Friday of the expiration month.

Key Terms: EXPIRATION

Most Dealers Offer FX Options That Are European-style, Not American

Options come in two styles: European style and American style.

European-style options can be exercised only at expiration.

American-style options can be exercised at any time up until expiration and at expiration.

The European-American naming convention has nothing to do with geography. You can buy and sell European- and American-style options anywhere in the world.
Most dealers offer FX options that are European style. They can be exercised only at expiration.

Exercising an options means that you take advantage of your right to buy or sell at the strike price. If you exercise a call option, you sell your call option for 0 premium and you go long the spot market at the strike price. If you exercise a put option, you sell you put option for 0 premium and you go short the spot market at the strike price.

An option that has time remaining on the contract may still have some value remaining. When you exercise, you sacrifice any remaining time value on the option to be long or short in the spot. At expiration, there is no more time value so it’s more common to exercise at expiration – hence this is why most dealers offer European-style options.

More information about the value of options is covered later in this chapter.

Key Terms: AMERICAN STYLE | EUROPEAN STYLE

Dealers Quote Bid and Ask Prices

An option’s price or premium is the amount of money the buyer pays to enter into the contract.

Dealers quote option prices in the quote currency at a price per unit of the base currency.

The total price that the buyer pays to enter into one contract is the quoted price times the contract size then converted into the dealer’s deposit currency such as dollars, euros or yen.

Dealers quote different ask and bid prices.

An ask price is the price at which the dealer will sell an option.

A bid price is the price at which the dealer will buy an option.

At a given moment in time, for a given option, a dealer’s ask price is always higher than their bid price. The bid-ask spread is a main source of dealers’ compensation.

Some texts use the words dealer and trader interchangeably. Here we use dealer to refer to a market-maker or a direct access entity to the marker in FX options. A dealer is ready, willing and able to be a buyer to all sellers and a seller to all buyers. Dealers quote bid and ask prices. We use trader to mean a price taker. A trader buys options from a dealer at the dealer’s ask price and sells options to a dealer at the dealer’s bid price.

In all financial markets for all financial instruments, the size of a dealer or exchange’s bid-ask spread is the strongest indicator of an instrument’s liquidity. The smaller the bid-ask spread, the greater the liquidity.

FX currency markets have some of the greatest liquidity of any financial markets.

Key Terms: ASK PRICE | BID PRICE

FX Call and Put Contract Specifications

An FX CALL-OPTION contract has these specifications:
  • Base/Quote currency pair
  • Strike price: The price expressed in the quote currency at which the holder is entitled to buy the base currency from the writer
  • Contract size: The number of units of the base currency that the holder is entitled to buy from the writer
  • Expiration date
  • Style: European or American
  • Option price or premium to be paid in quote currency
An FX PUT-OPTION contract has these specifications:
  • Base/Quote currency pair
  • Strike price: The price expressed in the quote currency at which the holder is entitled to sell the base currency to the writer
  • Contract size: The number of units of the base currency that the holder is entitled to sell to the writer
  • Expiration date
  • Style: European or American
  • Option price or premium to be paid in quote currency

To incorporate the Base/Quote price-quoting convention into our definitions, a call option gives the holder the right to buy so many units of the base currency from the writer at a strike price expressed in the quote currency.

A put option gives the holder the right to sell to the writer so many units of the base currency at a strike price expressed in the quote currency.

Key Terms: PUT OPTION

In the Money, At the Money or Out of the Money

At a given point in time, a call option is said to be “in the money” if the market price of the base currency is greater than the option’s strike price.

A call option is said to be “at the money” if the price of the base currency is equal to the option’s strike price.

A call is said to be “out of the money” if the option’s strike price is greater than the market price of the base currency.

Similarly, at a given point in time, a put option is said to be “in the money” if the market price of the base currency is less than the option’s strike price. A put option is said to be “at the money” if the price of the base currency is equal to the option’s strike price. A put is said to be “out of the money” if the option’s strike price is less than the market price of the base currency.

Key Terms: IN THE MONEY | AT THE MONEY | OUT OF THE MONEY

Intrinsic and Time Value

At any given point in time, an option’s intrinsic value is the value the option would have if it expired at that moment.

Hence, if an option is in the money, it has a positive intrinsic value.

If an option is at the money or out of the money, then it has an intrinsic value of zero.

An option’s time value is the difference between its market price and its intrinsic value:

Time value = Market price – Intrinsic value

The more time until the expiration date (Days to Expiration is often seen as DTE), then presumably the more expensive the option. If you hold the right to buy something at 1, it would naturally cost more if you could hold onto that right for 1 year rather than 1 month.

The non-intrinsic value is also affected by volatility. If the market place is more volatile, then the chances of its moving up or down (becoming more intrinsic) is increased and thus costs more. Sometimes the Time Value of an option is referred to as Volatility Value even though their theoretical computation is often discussed separately. To most options holders, the two are indistinguishable, so referring to either is typically meaning the same – the non-intrinsic value.

Key Terms: INTRINSIC VALUE

Put and Call Payoffs and Cash Settlements

If, at the time a call expires, the Base/Quote spot price is above the option’s strike price, then the option has a positive payoff:

Call payoff = Spot price – Strike price

If, at the time a put expires, the Base/Quote spot price is below the option’s strike price, then the option has a positive payoff:

Put payoff = Strike price – Spot price

If an option expires with a positive payoff, then the holder may either exercise the option or accept a cash settlement.

If the holder exercises a call, he or she buys the underlying currency from the writer at the call’s strike price.

If the holder exercises a put, he or she sells the underlying currency to the writer at the put’s strike price.

If the option has a positive payoff and the option settles in cash, then the holder receives from the writer a cash settlement:

Cash settlement = Payoff x Contract size

Keep in mind that both the spot price and the strike price are expressed in the quote currency.

Cash settlement is in the quote currency and is then converted into the dealer’s deposit currency such as dollars, euros or yen.

Summary

  • FX Options Expire
  • European and American Style Options
  • Bid and Ask Prices
  • FX Call and Put Contract Specifications
  • In the Money, At the Money or Out of the Money
  • Intrinsic and Time Value
  • Payoffs and Cash Settlements

Next: Chapter Three

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