Here’s why watching Forex options is important when trading
Forex options have the ability to move the market price and are an important factor in trading. This is a brief guide into how forex options work, and their impact on spot prices. First, let’s start with some basics.
What are options?
Options are contracts which can be purchased by paying a ‘premium’ amount for the right but not the obligation, to buy or sell an underlying instrument or asset at a specified price (‘strike’) for a specified date (‘expiry’). A option to buy is a ‘Call’ option, an option to sell is a ‘Put’ option. So, if you bought an option you would pick a price level that you would want your option to give you a position or protection in , in the underlying instrument, for a particular forward date in time.
The price (‘premium’) of these contracts rises or falls based on the prevailing price level of the underlying instrument versus the strike price, the moves in forward rates and time (decay). The premium of a call option increases in value the further the current market or spot price moves above the strike price. The value of a put option increases the further the underlying price falls below the strike price.
There are various types of options that have different rules and mechanics. Here are the three main options we tend to hear about. Most of these are from instituitional, not retail desks;
- Vanilla – These are plain and simple Call and Put options and the bulk of what is featured in our daily option expiry posts. They are active until expiry, no matter what the spot price in the underlying instrument is.
- Barriers – Barrier options are designed to pay out only if the price of the underlying instrument does not pass the barrier strike price by expiry. If the price does pass through the strike level, the barrier option is automatically expired as worthless to the buyer, and the seller (‘writer’) of the option banks the premium
- DNT (Double No Touch) – Similar to barriers but they have two strikes, above and below the current underlying price. A breach of either strike expires the options worthless.
Option sizes (the amount of a position that will be created in the underlying asset) can range anywhere from a few million to billions.
What is also worth noting here, is that options do not have to go to expiry. In fact, roughly 65% of speculative options do not reach expiry time but are sold out, bought back during the life time of the strategy.
How are options settled?
The options posted on the expiry board are mainly Vanilla, and for expiry that day at 10 am (New York), 14.00 GMT, in what is called the “New York cut”.
The other main daily expiry takes place at 3PM Tokyo time, although much less frequently used by non Japanese accounts.
An option will expire either ‘In the money’ or ‘Out the money’. ‘Out the money’ options expire worthless to the buyer and they lose the premium they paid for it (the seller, or writer of that option banks the premium), and no position is created in the underlying instrument.
‘In the money’ means the buyer will get to ‘exercise’ the option and create a position in the market. The seller of that option still gets the premium but also becomes the other side of the buyer’s trade in the underlying asset. I.e a Call option buyer becomes long, while the writer becomes short.
What happens at Expiry?
For call options, a buyer holding an ‘In the money’ option would gain a long position in the underlying asset at a price below the market/spot price at the time of expiry. For example, if at expiry the spot price was trading at 1.3000 and the call option had a strike of 1.2500, the buyer/holder of that option would become long at 1.2500, 500 pips below the spot price. If the buyer then sold the position at 1.3000, the profit would be 500 pips less the premium paid for the option. The opposite happens with put options. A buyer/holder would become short in the underlying market above the current spot price.
Why do we need to be aware of option expiries?
Options and expiries can move the market price, and sometimes this can be seen during quiet trading conditions and/or close to the expiry time. It is in the interest of the buyer to see the option expire in the money, and it is in the interest of the seller to see it expire worthless, and so we can often see the spot price gravitate towards, or stay close to, a level that has a large amount of options expiring, as both sides of an option can battle it out in the spot price to try to get the price to finish on the right side of their trade.
It’s not over once we pass the expiry time either, as options traders may then enter the market to close out their new positions. That can work both ways. A call holder who has become long may cover that position but the option writer has become short to the buyer’s long, so will need to cover that losing position too. If the positions are big enough, that covering may also move the market. Often though, options traders have usually already hedged their options positions which means we might not see this type of covering, unless the option derived position is one sided, where the buyer is a corporate who does not need to hedge, resulting in a position only for the writer.
The hedging activity, whether it’d be by option traders at banks, hedge funds, asset managers or other speculative or trading book managing entities (CB’s, CTA, brokers), will happen during the whole life of the option and is affected by mainly 2 factors: price and time decay, with forwards usually having a lesser impact unless in turbulent times.
For the sake of the example, let’s take the 1.2500 EURUSD call. Buyers of the 1.2500 EURUSD call option will get longer EURUSD as the price moves higher and may want to lock in some profits or start to play around with the delta amount that is generated as the price moves higher in order not to lose that part of the premium anymore in case the price would fail above 1.25 and by moving back down, reduce the premium value again or render the option worthless. If the price then falls again, they can buy this cash part back to pay for the lost option value.
Writers of the option are in the opposite scenario: In order to protect themselves against a further rise in EURUSD and losing premium + possibly more if the price rises by more than total premium value, they will need to buy some as we get closer, rise above 1.25, sell it back out sub 1.25 as the option risks not to get executed.
This, what we call gamma positive (buyer)/negative (writer/seller), activity around bigger option levels and notionals can influence the market into expiry and create opportunities for us as follows.
How can we apply all this to our trading?
Trading the spot price purely on expiring options is very difficult as there’s many factors to take into account. Just because we may hear that there’s a huge amount of options expiring at a particular level, it doesn’t mean the spot price will definitely move towards that strike price. The totals we report are the accumulation of all trades at that particular price level and so can be made up of hundreds of trades from hundreds of different traders, and those trades might have been put on for many different reasons, so not everyone will be looking to battle it out to get the underlying price on their side.
Occasionally we might hear that barriers and DNT’s are in play, and owned by single large investors, or perhaps a central bank, and those can be watched more closely for a possible trading opportunity. Players like the PBOC have been known to hold huge option positions and they have the means and the clout to protect them and move the price away from them, and thus some traders use that as an opportunity to trade ahead of those levels, knowing that there’s potentially a big backstop.
There is no definitive or sure-fire way to trade this information but if we are aware of it as part of our everyday trading information base, we can know what to look for, and be ready to act, if a price starts reacting a certain way around a certain time.
While the main expiry levels for Vanilla options are gained from the DTCC, we can hear from other market sources about other options like Barriers and DNT’s. Any information we provide is subject to our site Terms & Conditions.
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