21 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 2 - Option Types
Building Blocks
Having reviewed the terminology of FX options in the first section we now turn to the various option and cash position types that help provide us a foundation to build on in later sections. The ability to describe combinations of options and underlying positions in pictures is a powerful tool in gaining options intuition. This chapter introduces the basic building blocks, and some of the ways in which options and underlying positions can be combined to produce alternative profit & loss profiles.
Building Blocks
There are six basic building blocks to an options position:
The underlying position, if any:
- Long Cash
- Short Cash
And long or short options positions:
- Long Call
- Short Call
- Long Put
- Short Put
The six basic building blocks:
Long Forward
The simplest positions to understand are the underlying long and short cash positions. The long forward often represents an underlying long exposure, i.e. a need to sell the underlying base currency in the future.
The diagram simply shows that for a long position, as spot moves higher the position gains in value, but if spot goes down the position incurs a loss.
Short Forward
The short forward is often used to represent an underlying short exposure, i.e. a need to buy the underlying base currency in the future.
The diagram simply represents that as spot moves higher the position incurs a loss, but if spot moves lower the position gains in value.
Call Option
The holder of a call option has the right, but not the obligation, to buy the underlying currency at the strike price. It only makes sense to exercise the option if the strike price is a more favourable rate that can be obtained in the spot market on expiration day. If the market rate is lower than the strike price then the option will be left to expire worthless.
Long Call
If you own a call option you have the right but not the obligation to buy a currency at some future date.
The right to buy.....
The long call therefore has the upside features of a long forward position.
But not the obligation…
The long call does not have the unlimited loss potential of a long forward.
Short Call
The seller of a call option is obliged to sell the underlying currency if the holder exercises the option.
The short call therefore has the unlimited loss feature of a short forward position
… however, without the upside potential of the short forward.
Put Option
The holder of a put option has the right to sell the underlying currency at the strike price. It only makes sense to exercise the option if the strike price is a more favourable rate that can be obtained in the spot market on expiration day. If the market rate is higher than the strike price then the option will be left to expire worthless.
Long Put
If you own a put option you have the right but not the obligation to sell a currency at some future date.
The right to sell.....
The long put therefore has the upside features of a short forward position.
But not the obligation…
The long put does not have the unlimited loss potential of a short forward.
Short Put
The seller of a put option is obliged to buy the underlying currency if the holder exercises the option.
The short put therefore has the unlimited loss feature of a long forward position
… however, without the upside potential of the long forward.
Combining The Building Blocks - Synthetics
One way to gain a better understanding of the use of options is to use profit and loss profiles. The six building blocks can be combined to pictorially describe the resulting position. This is useful for describing the benefits of a particular combination of the building blocks. It is also useful for highlighting any undesirable risk characteristics.
Synthetic Long Put
Synthetic Long Call
Rules For Adding Building Blocks
- Where there is a strike price, the diagram will kink
- Divide diagram into zones
- Zones are defined by strike prices
- Draw resulting diagram a zone at a time
Risk Reversal
Call Spread
Risk Reversal + Long Forward
Seagull
Next Section - Common Option Strategies
In the next section we continue our introduction to FX options by looking at common option strategies.
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.