Work on financial market requires an extensive knowledge base from the participant. In this article, we will answer the question of what currency options are and how exactly they are used in the conditions of the modern market. Let's start with the most important thing - the definition.
So, currency options These are contracts between buyers and sellers. Thus, the buyer gets the right (an important point - the buyer is not charged, unlike the seller) to buy a given amount of currency at a predetermined cost, regardless of the current market value of the currency.
In this case, the seller, within the framework of a currency option, is obliged to transfer the currency to the buyer within a specified period (at the initiative of the buyer who wants to make a deal).
Currency as a tool in the hands of financiers
Currency options are truly unique trading instruments that are suitable not only for trading on the market, but can also be used to insure your own risks. Options make it possible to adapt an individual strategy to any market conditions. currency options on this stage vital for truly serious investors.
Note that the current value of an option is affected by a significantly larger number of factors than other currency trading instruments. So, in contrast to the same forwards or spots, low or high can create profitability in option markets. At this stage:
- Options are one of the most available tools foreign exchange trading
- Options - a guarantee of the execution of orders on time and the security of the transaction.
At this stage, currency options are very common on foreign exchange market. largest center option trading– USA, the second and third places respectively are occupied by England and Japan.
A currency option is a secondary instrument, because the option price is secondary to the current value of the RNV. And as practice shows, many traders do not evaluate all the possibilities of options and do not use them to the fullest.
Working with currency options
At this stage, options in the foreign exchange market are possible in the form of futures or for cash. Thus, you can trade options either OTC (over-the-counter, which means “over the counter”) or on centralized futures markets.
On modern market more than 80% of all transactions are made on OTS. It should be noted that OTC is almost completely identical to the markets. Employees communicate directly with banks, while the banks themselves trade either directly with each other, or they work in turn with brokers.
Work on OTC market implies maximum flexibility - any terms of the contract, any and any volume. Currency units can be fractional and integer, the cost of a unit is estimated not only in US dollars, but also in any other currency.
Options trading
At the present stage, any currency can be sold as an option - thus, traders operate with the value of even the most exotic currencies, if they are needed. There are no restrictions on the duration of validity - from a few hours to years. However, traders prefer whole numbers in their work - two weeks, three months, one year. And since RNV works around the clock, the time for trading options is unlimited.
At the beginning of our article, we already said that options trading gives the buyer the right, but does not impose any obligation to own currency futures. An advantageous difference from a currency futures contract will be that a financial reserve (the so-called margin) is not needed to purchase a currency option.
Experts have deduced seven main factors that have a direct impact on the final cost of the option. Factors:
- Currency value
- Its volatility
- Implementation cost
- Validity periods
- Difference in discount rates
- Type of contract (put or call)
- Option model (there is a European and an American one)
Of course, the main value-forming component is the price of the currency. All other factors are analyzed and compared taking into account its value. Any changes in the current value of the currency will necessitate the use of an option, and will also have a direct impact on profitability. The impact of the currency value on the option premium is measured using the Delta index.
Delta Index (A)
Delta is the very first derivative of the IPV (Option Pricing Model). Delta is denoted as A. This index can be considered in the following aspects:
- Change in the CVO (price of a currency option) in relation to the change in the value of the currency as a whole.
Let's take an example. The Delta index is equal to 0.5 in relation to changes in the value of the currency. Thus, if the market moves and the value of a currency rises by 10 percent, then the value of an option on that currency will increase by 5%.
Delta as a degree of risk insurance
The first derivative can be used as the degree of insurance against the risk of an option in relation to a currency future. Can be used to establish a balanced risk. Let's go back to the example - Delta is 0.5. In this case, it is necessary to use two option contracts at once for each of the futures contracts.
Equivalent Equity or Theoretical Position
In this context, "Delta" is a part of the currency futures, in which the buyer is in the "buy" (long) position, and the put buyer is in the short (sell) position. If a similar example is used (delta(A) is 0.5), then the buyer of the put option sells half (1/2) of the foreign exchange futures contract.
Of course, it is not always possible for a trader to guarantee the value of the spot market, futures or irreversible forwards - therefore, the Delta position may remain temporarily uninsured. In order to avoid a high price of insurance, as well as the risk of high volatility, a tradeo can act in this way - to insure positions of the original option with other options.
Methods of risk neutralization are usually called "Vega" and "Gamma" insurance.
Index "Gamma"
Briefly referred to as "G" and is better known to traders as the curvature of the option (option curvature). Gamma is the second derivative of the MTP (option pricing model). This is the degree of change in the Delta of an option or its sensitivity. For example, if an option in which Delta (A) is equal to 0.5 and Gamma (G) is equal to 0.05, should have a Delta (A) equal to 0.55 (with an increase in the value of the currency by one point). Accordingly, when the price goes down, the Delta will be 0.45 (price drop by 1 point).
Most importantly, the higher the Gamma index, the higher the sensitivity will be. This index is measured from 0 to 100%.
Vega Index
The Vega index is a measure of the effect of volatility on the value of an option. The index also characterizes the sensitivity of the theoretical value of a currency option to changes in its volatility.
As mentioned above, a currency option is sold only in a certain time period - after its expiration, the "expiration date" comes - the expiration date. If the buyer wants to exercise the option, he must inform the seller of this on the day of expiration or on the eve of expiration. If the "expiration date" was missed, then the seller is automatically released from his legal obligations and it becomes impossible to exercise the currency option after the expiration date.
Index Theta (T)
This index stands for "extinction of an option over time". Theta is used when, due to the slow movement of the price of the currency (or lack of movement), the value of the currency option disappears.
Let's take a simple example. If the T index is equal to 0.2, this means a loss of 0.02 of the value of the currency option daily (on days when the value of the currency remains unchanged). At the same time, it does not depend on time, but the external one directly depends.
As the expiration of a currency option approaches, the Theta index (extinction in time) increases. This is explained quite simply - the number of possible conclusions regularly decreases over time.
In the foreign exchange market, there are so-called. bid-offer spreads that make trading and selling options or trading irreversible forwards extremely expensive. So, if a currency option turned out to be very deep into the money, then the difference in discount rates that was achieved with its quick execution can directly exceed the cost of the currency option.
And if the volume of a currency option is very small, or its expiration date is close (in this case, the value of the option consists only of the intrinsic value), earlier its execution is preferable and most profitable for the trader.
Conclusion
Determining Factors currency options are extremely complex - as a result, for many traders, the procedure for calculating the value of a currency option is very difficult. However, in the absence of a pricing model as such, options trading is a bit of a gamble with a very low degree of efficiency and a high probability of losing.
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A currency option is a contract between a buyer and a seller that gives the buyer the right, but not the obligation, to purchase a certain amount of currency at a predetermined price and within a predetermined period, regardless of market price currency, and imposes on the seller (writer) the obligation to transfer the currency to the buyer within a specified period, if and when the buyer wishes to carry out an option transaction.
A currency option is a unique trading instrument that is equally suitable for both trading (speculation) and risk insurance (hedging). Options allow you to adapt the individual strategy of each participant to market conditions, which is vital for a serious investor.
The prices of options, compared to the prices of other currency trading instruments, are influenced by a larger number of factors. Unlike spots or forwards, both high and low volatility can create profitability in the options market. For some, options are a cheaper currency trading tool. For others, options mean greater security and the exact execution of orders to close a losing position (stop-loss orders).
Currency options occupy a rapidly growing sector of the foreign exchange market. Since April 1998, options occupy 5% of the total volume on it (see Fig. 3.1.). The largest option trading center is the US, followed by the UK and Japan.
Option prices are based on and are secondary to RNV prices. Therefore, an option is a secondary instrument. Options are commonly referred to in connection with risk insurance strategies. Traders, however, are often confused about both the complexity and ease of use of options. There is also a misunderstanding of the possibilities of options.
In the foreign exchange market, options are available for cash or in the form of futures. From this it follows that they are traded either “over the counter” (over-the-counter, OTC), or on a centralized futures market. The majority of foreign exchange options, approximately 81%, are traded OTC (see Figure 3.3.). This market is similar to the spot and swap markets. Corporations can contact banks by phone, and banks trade with each other either directly or through brokers. With this type of dealing, maximum flexibility is possible: any volume, any currency, any term of the contract, any time of the day. The number of currency units can be integer or fractional, and the value of each can be estimated both in US dollars and in another currency.
Any currency, not just those available in futures contracts, can be traded as an option. Therefore, traders can operate with the prices of any, the most exotic currency that they need, including cross-prices. Any validity period can be set - from several hours to several years, although basically the terms are set, focusing on integers - one week, one month, two months, etc. RNV works continuously, so options can be traded literally around the clock.
Trading options on currency futures gives the buyer the right, but does not impose the obligation, to physically own the currency futures. Unlike futures currency contracts, you do not need to have an initial cash reserve (margin) to purchase currency options. The option price (premium), or the price at which the buyer pays the seller (writer), reflects the overall risk of the buyer.
The following seven main factors affect option prices:
1. Currency price.
2. Selling price (strike (exercise) price).
3. Currency volatility.
4. Validity.
5. The difference in discount rates.
6. Type of contract (call or put).
7. Option model - American or European.
The currency price is the main pricing component and all other factors are compared and analyzed taking into account this price. It is the changes in the price of the currency that determine the need to use the option and affect its profitability. The impact of a currency's price on an option premium is measured by the "Delta" index, the first Greek letter used to describe aspects of pricing when discussing factors that affect the value of an option.
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Delta
Delta, or simply A, is the first derivative of the option pricing model (OPP). This index can be viewed in three aspects:
1. As a change in the price of a currency option (CVO) relative to a change in the price of a currency. For example, a change in the price of an option from A=0.5 is expected to be half the change in the price of the currency. Therefore, if the price of a currency rises by 10%, the price of an option on that currency will rise by an estimated 5%.
2. As the degree of risk insurance (hedge ratio) of an option relative to a currency futures, necessary to establish a balanced risk (neutral hedge). For example, if A=0.5, you will need two option contracts for each of the futures contracts.
3. As a theoretical or equivalent equity position. With this approach, the “Delta” is a part of the currency futures, in which the buyer of the call is in the “buy” (long) position or the buyer of the put is in the “sell” (short) position. If we use the same indicator A=0.5, this would mean that the buyer of the put option sells 1/2 of the currency futures contract.
Traders may not be able to guarantee prices in the spot, non-reversible forward or futures markets, leaving the Delta position temporarily unhedged. To avoid the high cost of insurance and the risk of unusually high volatility, a trader can hedge positions in the original option with other options. Such methods of risk neutralization are called "Gamma" or "Vega" insurance.
Gamma
Gamma (G) is also known as the curvature of the option. This is the second derivative of the option pricing model (OPM) and represents the degree of change in the option's Delta, or the sensitivity of the Delta. For example, an option with A=0.5 and Y=0.05 is supposed to have A=0.55 if the price of the currency rises by 1 point, or A=0.45 if the price falls by 1 point. "Gamma" varies from 0 to 100%. The higher the Gamma, the higher the Delta sensitivity. Therefore, it may be appropriate to interpret "Gamma" as an indicator of the acceleration of the option in relation to the movement of the currency.
Vega
"Vega" characterizes the effect of volatility on the premium value for an option. "Vega" (Ξ) characterizes the sensitivity of the theoretical option price to changes in volatility. For example, Ξ=0.2 creates a 2% increase in premium for every percentage increase in estimated volatility and a decrease in premium by 2% for every percentage decrease in estimated volatility.
An option is sold for a specified period of time, after which there is a date known as the expiration date. A buyer wishing to exercise an option must notify the writer of this on or before the expiration date. Otherwise, it releases the writer from any legal obligations. The option cannot be exercised upon expiration.
Theta
Theta (T), an index also known as fading over time, is used when the theoretical value of an option is lost due to very slow or no currency movement at all.
For example, T=0.2 means losing 0.02 premium for each day the currency price does not change. The internal price does not depend on time, but the external one does. The fading in time increases as the expiration approaches, as the number of possible exits continually decreases over time. The influence of the time factor is maximum for the at-the-money option and minimum for the in-the-money option. The degree of influence of this factor on the out-of-the-money option is somewhere within this interval.
Bid-offer spreads in the foreign exchange market can make selling options and trading irreversible forwards too costly. If the option is deep into the money, the difference in discount rates achieved by the quick exercise may exceed the value of the option. If the option is small or close to expiration and the value of the option consists only of its intrinsic value, early exercise may be preferable.
Due to the complexity of the determinants, calculating the price of options is difficult. At the same time, in the absence of a pricing model, options trading is nothing more than an inefficient gamble. One idea for pricing an option is to treat buying your own currency as foreign currency at some price X is the equivalent of an option to sell foreign currency for one's own at the same price X. Thus, a call option in one's own currency turns into a put option in a foreign one and vice versa.
A currency option is a contract concluded between the seller (it is customary to call him a writer) and the buyer (holder) of the option. In accordance with the contract, the seller is obliged to buy or sell a certain amount of currency at a set price at any time, up to the expiration of the contract. As for the option buyer, he acquires the right to buy or sell the currency at the price set by the contract only if it is profitable for him. This is the most important difference between options on the one hand and forwards and futures contracts on the other. Indeed, forward and futures contracts must be executed in any case, both parties must settle with each other on the day the currency is delivered. A different situation arises in the case of a currency option, which gives its holder the right, but by no means the obligation, to make a currency transaction in the future at a predetermined rate.
Currency options form a relatively young segment of the urgent currency supply market. Options trading in the modern sense of the term has been conducted in the United States since 1981. largest center such a trade is Philadelphia stock Exchange. Prior to that, there was a market in Europe where they traded a special type of options issued by large banks (over-the-option). Distinguish between buy options and put options. Buyer options (call option) give the buyer the right to buy foreign currency at the underlying price or the exchange rate of the option. Seller options (pull option) give the same right to the buyer, but not to buy, but to sell foreign currency. Options are traded on a 9-month cycle. The option expires on the Saturday before the third Wednesday of the month if paid on the same Wednesday. Depending on the estimated payment term for the supply of currency, a European option and an American option are distinguished. European option (european option) can only be paid on the expiration date of the contract. An American option provides the buyer with greater freedom of choice, allowing the trade to be made throughout the life of the contract, including the day it is settled. Operations in the futures foreign exchange market are carried out in order to profit from the exchange rate difference between currencies. Unlike forward and futures contracts, an option allows you to reduce the risk arising from adverse changes in exchange rates, and retains the possibility of making a profit in the event of favorable developments. The value of the option is calculated on the basis of the so-called option premium, which is a fixed amount, for example, in cents, paid from each unit of foreign currency - pounds sterling, Canadian dollars, Japanese yen, etc. In order to determine the price of the contract, you need to multiply the premium by the amount of foreign currency presented in the contract.
An option is a kind of contract that allows you to exchange one currency for another if the transaction turned out to be winning for you and refuse such an exchange if the transaction is not profitable.
In general, there are 2 types of options: put and call. The first allows you to sell a predetermined amount of currency strictly on a predetermined day at a fixed price, and the second allows you to buy foreign currency under the same conditions.
With a deposit cover, which banks offer to their customers, is a carefully organized investment product that includes such financial instruments as a deposit and. A deposit-backed deposit gives you the opportunity to earn a higher interest rate than a regular deposit, but also exposes your savings to currency risk.
- It is likely that in the end you will be able to get more impressive income than just on a deposit;
- More flexible choice of currency pairs, profitability, term and rate;
- The placement period is short: from 1 week to 3 months;
- Already after 2 placements through a bank branch, it is possible to conduct it online.
If you are a happy owner of foreign exchange savings or assets and liabilities in different types currencies, and also if you have your own opinion on possible changes in exchange rates, then the option of investing in currency options suits you. Unless, of course, you want to invest and are not afraid to take risks.
Having chosen this type of investment, you must choose the base and alternative currency pairs, the placement period and the exchange rate. The investment itself will be made in the base currency, but can be transferred to an alternative currency at the exchange rate you set earlier. Your earned income in the event of a successful trade is the option premium earned through a combination of currency pairs, placement times and exchange rates.
So, you have decided to take up this type of investment. For this you should:
On the opening day of the option:
- Place a specific amount in the previously selected base currency. It can be Euro, USD, Russian Ruble, British Pound Sterling, Swiss Franc or Japanese Yen. Base currency options may vary from bank to bank.
- Choose a second currency.
- Set the placement period from the range of 7-90 days.
- Set the exchange rate and premium for placing the option. Remember that the higher the premium, the greater the risk.
On the day the option is determined:
- Further actions depend on whether or not your currency option will be exercised:
A) If the current rate is less favorable or equal to the exchange rate you have determined, then on the return day you will receive the investment amount, % on the deposit and an option premium in the base currency
B) If the current exchange rate turned out to be more profitable than you determined, then you will receive all the amounts due to you in an alternative currency.
Surely most of those reading the article were interested in the question: how is the option premium determined? The option premium due to you is paid by the trader who purchases your option. This investment option, combined with the accrual of interest on the deposit, will bring you high income, which will depend on the movement that is observed (occurs) in the currency market during the period when you make an investment.
Let's take an example of how this system works. Let's say you assume that the value of USD over the next week will increase from 78 to 87 rubles. Since you expect the currency to rise, you decide to choose call options. You then purchase the options, with all due fees, from the broker. If by the time the option is exercised, the USD rate is really gaining growth, then the price of the option also increases. In this case, you do not need any further investment. An option can either be held until its expiration date or sold ahead of time.
How to profit from currency options?
This type of investment attracts great amount speculators, because it allows you to get unlimited income with a clear fixation of probable losses. However, if holding an option is profitable business why in the end there are still those who want to sell them? The answer to the question lies in the fact that the size of the premium received by the seller of the option is commensurate with the risk of probable unlimited losses.
Is it worth getting involved in option contracts in this case? You can only become a successful bidder if you are the first to know about future rate changes that other bidders are not aware of. Otherwise, your competitors in the field of foreign exchange transactions would also want to make a profit that significantly exceeds the option premium.
Like every income-generating activity, this kind of investment has a number of disadvantages:
- Inflated transaction prices compared to other types of investments;
- This type of investment requires deep knowledge in the field of finance, as well as experience. Currency options are difficult to understand, not everyone will be able to start in this area.
- In addition, this type of investment is very time bound. In this regard, the vast majority of contracts remain unfulfilled.
As you can understand, this way of earning additional income is not as simple as we would like. Whether it is worth taking risks and starting work in this direction risking your money is up to you.
Issue securities, which are used as part of derivative instruments, can be classified as monetary options (Option) for a number of reasons. Main hallmark such a derivative is the variability of buyer behavior. So, if the term of the contract and the cost suit the owner, he sells his asset.
If the price does not satisfy the owner, the currency option (VO) is not sold. VO itself is a way of managing monetary assets. The type of securities administration is actively used in the banking sector and on exchanges with a limited circulation of currencies. In any contract that falls under the VO, the following points are necessarily reflected:
- The type of document according to which the scope of the buyer's rights is determined;
- Installed object contractual relations– specific currency pair;
- The price at which the contract is to be settled. The value of the asset is determined, upon reaching which another transaction should take place - for the sale or purchase of the subject of the agreement;
- The validity period sets the period of legal capacity of the currency option holder. The duration of a derivative instrument based on domestic circulation may be limited to a few days or months;
- The instrument premium is paid to the new holder of the asset at the time of the agreement. It is understood that not so much the benefit of the buyer as compensation for certain risks that will arise in the future. The reward is often understood as fair value holding of type Option.
Main types of currency options
According to the agreement, which is concluded between two market participants, contracts give the right to acquire or sell the underlying assets in hand. In this regard, the same pair of instruments are used in the practice of the stock market:
Option call
An agreement under which the party to the relationship receives the right to acquire shares on standard terms. The selling price is set in advance and remains unchanged until the expiration date of the transaction. For the fact that the seller acquires an asset, regardless of the state of the market, he receives a certain reward.
A currency option is an opportunity to profit from fluctuations in the exchange rate. The expectation of buyers is that the value of the acquired asset will increase over the term of the contract.
Call, as a tool, allows you to minimize the risks of market participants, since it guarantees the preservation of the price range. This is what distinguishes it from traditional investments in monetary pairs. Let's see how the Call contract is applied. For example, a trader purchases a lot to buy euros at the current exchange rate (60 rubles).
The buyer's calculation is to expect a price increase within the term of the contract. The contract is valued at a premium of 5 percent of the purchase price. So, if the desired purchase amount is 1500 euros, then the reward will be 75 euros, respectively. To obtain a positive profit, it is necessary that the growth in the expected period be more than 5 percent.
Most often, such an instrument is used to cover the possible risks of an already formed investment portfolio. You can earn on it both on an increase and on a decline in the course. To do this, the currency is sold at a price that is fixed at the current value for the day of sale. Such transactions can be concluded, for example, in anticipation of the expected decrease in the exchange rate.
As with CALL, the trader pays a 5 percent premium for buying a 20 percent declining euro worth 10,000 euros. A subsequent sale to a securities broker will earn a difference of 15 percent of the lot, i.e. 1,500 euros.
Talking about what is a currency option, it is impossible not to mention the American, Asian and European derivatives. In many ways they are similar, but each has its own advantages. Entering the market according to a certain model contributes to good earnings for a trader.
Thus, the American Call or Put gives the buyer the right to assert his rights to the transaction ahead of schedule. This is especially beneficial for cases of positive price dynamics. With a strong increase or decrease in the base value of an asset, its owner may carry out the conversion ahead of schedule.
The European-style contract is distinguished by low commissions for the purchase. Such an instrument reduces the risks of the seller due to the prohibition on early expiration - until the expiration date of the contract comes, it is not possible to convert the currency. It is impossible to make a profit from binary options at intermediate values of the asset price.
The agreement on the right to choose the price in the future according to the Asian model has a commodity basis. The main difficulty in working with this derivative is to determine the price parameter. As a generally accepted calculation for determining the value of a derivative, the average statistical data on underlying assets for a specific period of time is used.
Barrier and binary options
The investment method is designed for those who prefer to hit the big jackpot. True, an unsuccessful outcome of the transaction can lead to a complete loss of the market participant's assets. The barrier contract implies a pre-given acceptance of risk, while the sale price is set at the bar that is most beneficial for the seller.
Even despite the fact that such contracts are classified as high-risk, the share of underlying assets in the market is gradually decreasing. Barrier derivatives are mutually beneficial for both parties. The seller saves his time, and the buyer is protected from additional risks of losing capital.
Binary options: the essence of the transaction is to guess the behavior of the value of a currency or other financial instrument during certain period. If a trader bets on a price increase, you should buy a Call. If you plan to make a profit on a fall, you need to bet on Put.
Derivatives and the banking sector
The possibility of choosing a liability is provided not only in the stock market. You can invest in securities through second-tier banks (all except the central institution). To purchase shares to an individual a deposit is opened in one of the national currencies, which is used as a security for the transaction.
The use of this method, on the one hand, allows you to get an increase in your deposit. On the other hand, there is a high risk of losing your savings. In fact, the bank in such relations acts as a broker, giving its client the right to purchase a Put transaction. The contract stipulates in advance the exchange rate and the amount of remuneration to the credit institution. The practice of participation confirms the mediocre benefit for the client: the conditions of the bank are usually drawn up not in favor of the investor.
