Currency Options Trading - Chapter 6

Options on currencies operate almost in the same way as way as options on any stock, index or commodity. The only difference is that currency options are also quoted and traded in pairs. Like other equity options, currency options also have strike prices, maturities, spot price and an option price. Like in case of equity and index options, currency options also offer call and put options which are the right to buy and sell respectively

5 Basic Things To Know About Currency Options

Like in the case of options on equities and indices, currency options are also a right (without an obligation) to buy or sell a currency pair. In terms of rupee currency pairs, there are options on USDINR, GBPINR, EURINR and JPYINR. Let us look at 5 basics of currency options.

• The right to buy the currency pair is called call option and the right to sell the currency pair is called put option
• The pre-specified price is called as strike price and the date at which the strike price is applicable is called expiration date
• The gap between the date of entering into the contract and the expiration date (in number of days) is called time to maturity
• The buyer of the call / put option pays premium to the seller of the call / put option. Buyer has limited loss but unlimited profits and the reverse is true for option seller
• The asset which is bought or sold is also called as an underlying or underlying asset and in case of currency options it is the currency pair

Position limits – currency options:

• Client level: Gross open position (across all contracts for futures and options on USDINR) shall not exceed 10% of total open interest or USD 10mn whichever is The exchange alerts clients when gross open position exceeds 3% of total open interest at the end of the previous day’s trade.
• Trading member level: Gross open position of the trading member (across all contracts for futures and option on USDINR) shall not exceed 15% of total open interest or USD 50mn whichever is higher
• Bank: Gross open position of a trading member bank (across all contracts for futures and option on USDINR) shall not exceed 15% of total open interest of USD 100mn whichever is higher
• Clearing member level: No separate limit has been specified for a clearing However, clearing member’s own positions and position of trading member clearing through him should follow the limits as specified above

Dissecting A Currency Options Contract

Data Source: NSE

What does the above live currency options chart represent?

• The contract is a call option (right to buy) the USDINR contract expiring on 28^th August having a strike price of Rs.71.50.
• The price of the call option (option premium) is Rs.0.0725. It can be seen that the price has fallen sharply during the day due to strengthening of the INR during the day.
• There are two traded values here. The traded value represents the total lots multiplied by the lot size multiplied by the strike price. The other definition of value is premium value which is much lower.
• Open interest shows the number of lots of the specific contract that are still open in the market at this point of time.
• All currency options are, by default, European options; meaning they can only be exercised on the date of expiry. They can be reversed at any time before that.

Rupee Currency Options And Cross Currency Options

Like in the case of currency futures, you have rupee pairs and cross currency pairs in currency options too. Cross currency pairs are non-rupee based pairs. Let us first look at the sample of rupee pair options on the NSE and their contract specifications.

Data Source: NSE

Like in case of currency futures, the currency options on rupee pairs are also available on the same four pairs. How do you trade currency options? If you expect the dollar to strengthen versus the rupee, you can buy a call option on the USDINR. You can select the strike price based on your view. Similarly, if you are expecting the dollar to weaken versus the rupee, you can buy a put option on the USDINR. In case of options, while the lot size is denominated in the international currency value, the premiums are denominated in Indian rupees. Let us now turn to cross currency options.

Data Source: NSE

Cross currency options are denominated in the principal currency that is the first currency of the pair. However, the option premiums even for cross currency options are denominated in rupees only.

Moneyness of Currency Options (ITM / OTM / ATM)

When are options valuable to the buyer of the option? For example, the buyer of the call option would exercise his right to buy only if the spot price of the currency pair is higher than the strike price on the maturity date. On the other hand, the buyer of a put option would exercise his right to sell only if the spot price of the currency pair is lower than the strike price on maturity date. There are also transaction costs and statutory costs but for simplicity purpose, we will ignore them for the time being.

In simple terms, moneyness of an option indicates whether the contract would result in a positive cash flow (in-the-money), negative cash flow (out-of-the-money) or zero cash flow (at-the-money) for the option buyer at the time of exercising it. Therefore, based on moneyness, options can be classified under 3 categories as under.

In the money (ITM) option:

For Call Option it is ITM if the (Spot Price > Strike Price)

E.g. If USDINR call option of Rs.72 strike is having spot price of Rs.72.50, it is ITM

For Put Option it is ITM if the (Strike Price > Spot Price)

E.g. If USDINR put option of Rs.72 strike is having spot price of Rs.71.50, it is ITM

Out of the money (OTM) option:

For Call Option it is OTM if the (Strike Price > Spot Price)

E.g. If USDINR call option of Rs.72 strike is having spot price of Rs.71.50, it is OTM

For Put Option it is OTM if the (Spot Price > Strike Price)

E.g. If USDINR put option of Rs.72 strike is having spot price of Rs.72.50, it is OTM

In the money (ITM) option:

For Call Option and put options it is ATM if the (Market Price = Strike Price)

Since ATM options are practically difficult, traders consider the two contiguous strikes as near the money (NTM), which is an extended version of ATM options.

Option Pricing And Concept Of Intrinsic Value

There are some basic formulae we will draw from our discussion till now.

The option price or option premium can be defined as (intrinsic value + time value)

Intrinsic value is fairly straight forward because it is measured by moneyness. The residual value in the option premium is the time value. Time value of the option is one of the most important concepts and helps in options trading.

Illustration 1: The USDINR September call option of 70 strike price is quoting at a premium of Rs.0.80 when the UDINR spot price is at Rs.70.60. What is the intrinsic value and time value of the option?

In the above case; intrinsic value of call = (Spot – Strike) = (70.60 – 70) = Rs.0.60

Time Value (residual value) = (Option premium – Intrinsic Value) = (0.80 – 0.60) = 0.20

While the intrinsic value of the option above is based on moneyness, the time value is based on time to expiry and the volatility of the stock price. From the above we can conclude 3 things about pricing of options.

1. ITM options have intrinsic value and time value
2. ATM / NTM options have larger proportion of time value than intrinsic value
3. OTM options have only time value and zero intrinsic value.

Black & Scholes Model For Options Pricing

The Black and Scholes model uses a five factor model to value options. The table below captures the gist of the model parameters and how the factors impact the call and put options.

As you can see from the above table, it is only in case of volatility and time to expiry where the call and the put options on the currency pairs are impacted in a similar manner. That is because volatility and time make the call and put valuable as they increase. Unlike the equity option where we used the risk-free rate, in case of currency option, we look at the movement of interest rate differential. In case of USDINR, you track the movement of the Indian interest rate – US interest rates.

Five Options Greeks You Should Know About

Option Greeks indicate the price sensitivity of option to change in price determinants and are normally used by more sophisticated traders in the currency options market. However, it would be useful to know that these Greeks mean. Here are 4 popular Greeks.

• Delta: is the rate of change of option price with respect to the spot price. Delta of a long call option (or short put) is positive and ranges between 0 and +1. Delta for a long put (short call) is negative and ranges between 0 and -1.
• Vega: measures the rate of change of option value to volatility of price of the underlying asset. It is always positive for long options and negative for short options.
• Theta: is also called time decay and is useful for option writers. It measures the change in the value of the option with respect to the passage of time. If you buy an option you are short theta and if you sell an option, you are long on theta.
• Rho: It measures sensitivity of option value to the risk free rate.

Annexure: Option Payoff Diagrams For Calls And Puts