7 January, 2022
I build businesses, both as independent startups and as new initiatives within large global companies. This series of posts is based on an FX Options training course that I delivered whilst contributing to building FX businesses at a number of investment banks. If you are looking to build a business and require leadership then please contact me via the About section of this website.
FX Options Guide - Section 1 - Terminology
Introduction To Options Terminology
What Is An Option?
An option is a financial contract which provides protection against adverse movements in an underlying asset, whilst maintaining the potential for gains from favourable moves.
An option is a one-sided forward contract. When you enter an “on market” forward, neither side has to make an up-front payment to the other. The “On market” forward rate corresponds to “arbitrage free rate”. A forward has potential for unlimited profit or loss (symmetry). With an option, you only obtain the upside (or beneficial part of the forward contract). Also, with an option you are not constrained to the arbitrage free rate and so the option is usually off-market.
Options Terminology
An option contract is described by the following terms:
- Expiration Date (t)
- Underlying
- Call or Put (C or P)
- Exercise style
- Strike Price (K)
- Contract Size (Notional Amount)
- Option Premium
Call Option Definition
An option giving the holder the right, but not the obligation, to buy a currency at the strike price.
Put Option Definition
An option giving the holder the right, but not the obligation, to sell a currency at the strike price.
Definition of Exercise
To exercise the right to buy or sell the underlying currency at the strike price.
European Exercise Style Versus American Exercise Style
- European options can only be “exercised” on their expiration date.
- American options can be exercised any time after their purchase.
Do not confuse with American/European quoting conventions in FX world.
Most Over-The-Counter (“OTC”) FX options are European style. It is unlikely that interest rates could change enough to cause the holder of a FX option to want to exercise the option to get the benefits of holding the underlying currency (unlike in equity options where dividend surprises are more common). Exchange-traded options are, more often, American style exercise, mainly for historical reasons (both types of exercise are traded on PHLX).
How Are Option Premiums Quoted?
Option premiums can be quoted in many ways, for example, in domestic currency units, in foreign currency units, or as a % of the notional face in either currency:
- USD per 1 EUR
- EUR per 1 USD
- % of USD Face Amount
- % of EUR Face Amount
The interbank market most often quotes in terms of volatility, i.e. 10.3 - 10.5.
Next Section - Option Types
In the next section we continue our introduction to FX options by looking at option types.
About The Author
I build businesses, both as independent startups and as new initiatives within large global companies. If you want to know more then visit the About section of this website.