Options in FX
Well, first of all options in the FX market are entirely different from equities. The cash market being extremely liquid, the options in most cases can be hedged almost perfectly. For instance, if an option has a barrier (as a simple example, the one-touch bet - payout if level say 1.95 in cable is touched at any point duting the life of the option) and spot is a pips away from the barrier with 10 mins left to expiry, you can imagine there is a significant amount at stake for the players. Apart from talks of "defending the barrier etc" to perfectly hedge this one has to take positions several times (sometimes a 100 times) of the notional of the bet, and FX is perhaps the only market where people can be confident of getting such liquidity. If the same option had a US share as underlying, the supply would simply not permit this level of hedging, and regulations are an issue as well.
The other difference is that while in indices like S&P, if you want to hedge a portfolio, its much easier to go the exchange and buy futures or options on the S&P instead of dynamically buying the shares underlying the index (500 in this case). In FX though most transactions, say 96%, occur through the interbank market. This means exceptional flexibility in choosing the date, cut, size, payoff profile, etc. At the end of the day a sizeable deal is most likely going to be like a yard placed with one investment bank, and that bank in turn hedges itself with other banks in the market. Thus most banks know the presence of massive options in the market, information that is privileged. As private traders we can hardly hope to hear about the details of such options.
Finally how would such options affect the market? The two most visible effects in my opinion are:
(1) When there is a massive barrier in the market that is being protected, in effect making it a high importance S/R level until the option expires. Note that just like S/R, the objective observer just stands aside and see who's winning instead of taking sides
and if the barrier is indeed breached, usu there is a huge stop loss order in the market to hedge it.
(2) If there is a sizeable option in the market expiring today, spot is close to the strike, and the market is long this option. Now in this case the market is long Gamma and the traders take profit every time spot moves 10 pips or so from the strike, they take profit (age-old habits of taking profits early maybe!) and the net effect is spot stays glued to it until the expiry time, usu NYK cut.
Hope that helps.
