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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.
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.
An option contract is described by the following terms:
An option giving the holder the right, but not the obligation, to buy a currency at the strike price.
An option giving the holder the right, but not the obligation, to sell a currency at the strike price.
To exercise the right to buy or sell the underlying currency at the strike price.
European Exercise Style Versus American Exercise Style
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).
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:
The interbank market most often quotes in terms of volatility, i.e. 10.3 - 10.5.
In the next section we continue our introduction to FX options by looking at option types.