T2W Trading Community

OPTIONS

1. Introduction

An option represents the right but not the obligation to buy or sell an underlying asset at a given price (the “strike” or “exercise” price), on or before a future date (i.e. “expiry”). Currency options are traded on the New York Board of Trade and its Dublin-based FINEX division. Investors can also trade options in currency futures on the International Money Market (IMM), a division of the Chicago Mercantile Exchange (CME). The private investor can access all these markets through margin brokers.

Options are the most fascinating and intellectually challenging of the derivatives and deserve a much more detailed treatment than can be presented here.
One warning; the theory of options is underpinned by some Nobel Prize-winning financial mathematics devised by Fischer Black, Myron Scholes and Robert Merton in the 1970’s. Scholes went on to found the Long Term Capital Management (LTCM) hedge fund, which nearly brought down the world financial system in 1998. Engrave that on your mind.

2. Option styles

There are two styles of options: -

• American-style which can be exercised at any time up to expiry
• European-style which can only be exercised at the formal expiry date.

3. Exchange-traded and over-the-counter currency options

Exchange-traded currency options are standardised American-style contracts that are bought and sold anonymously on recognised exchanges like NYBOT and FINEX, with quarterly expiry dates in March, June, September and December. The underlying currency pair is usually a “major” (i.e. a pairing with USD) although some crosses are available.

Exchange traded options are cleared and settled through official clearing houses (e.g. the New York Clearing House), which guarantees that contracts are honoured.

Over the counter (OTC) options are flexible arrangements negotiated between parties known to one another and conducted and settled outside the exchanges without the safeguards of the official clearing houses. OTC options can be American or European-style.

4. Puts and calls

There are two kinds of currency options: -

• Calls that give you the right (but not the obligation) to buy a currency pair at a set exchange rate (the “exercise rate” or “strike rate”), on or before a specific date (i.e. expiry).
• Puts that give you the right (but not the obligation) to sell a currency pair at a strike rate on or before formal expiry.

Put and call options can be bought or sold (“written”). When you buy an option you are said to hold a “long” position. If you sell (write) an option then you are said to hold a “short” position.

4.1 Long/short calls and puts

There are four basic option positions, which can be adopted singly or in combination for strategic purposes: -

*but not the obligation

Each option has a price or “premium”. As with other financial commodities there will be a bid price and an offer price.

4.1.1 Reciprocal calls and puts

Because purchase of one currency entails the simultaneous sale of another, it follows that each currency option involves one call and one put.

• A long call option on GBP/USD means that A has bought the right (but not the obligation) to buy GBP from B at the strike rate in USD. The mirror transaction is that A has bought the right (but not the obligation) to sell USD to B at the strike rate in GBP.
• A short call on GBP/USD means that A has sold B the right (but not the obligation) to buy GBP from A at the strike rate in USD. The mirror transaction is that A has sold the right (but not the obligation) to B to sell USD to A at the strike rate in GBP.

A GBP/USD call is therefore equivalent to a USD/GBP put.