What is Currency Option Trading?

What are Currency Pairs?

A currency pair is somewhat different to other assets. While it is true when you purchase a stock or a bond you exchange your cash for an asset, with a currency pair you are exchanging one currency for another currency. The currency you swap does not necessarily need to be your base currency. 

For example, if you live in the US and your base currency is the US dollar, you can trade a currency pair that does not have the dollar as one of the two currencies in the pair. You might trade the Euro versus the Yen, or the British Pound versus the Swiss Franc. A currency pair has an exchange rate that gyrates as market sentiment changes. If you speculate on the direction of a currency pair, you are betting on the direction of the exchange rate. 

What is an Option on a Currency Pair?

First, let’s start with the definition of an option. Options consist of two types — calls and puts. A call is the right but not the obligation to purchase a currency pair at a specific exchange rate on or before a certain date. A put option is the right but not the obligation to sell a currency pair at a specific price on or before a certain date.

The price that you agree to purchase or sell an underlying currency pair is called the strike price and the date when the option will expire is called the expiration date. The cost of a currency option is called the premium.

An option on a currency pair can come in several forms: you can purchase or sell an option on a currency futures contract, a currency ETF, a currency contract for difference (CFD), or an OTC currency pair

How is the Value of a Currency Option Determined?

The simple answer to this question is “by market participants.” Options, like other assets, are purchased and sold by market players. Options are usually bought and sold by market makers who then provide a bid and offer price to investors. Determining the value of an option can be slightly more complicated.

There are several components to an option. To find the value of an option, you are looking for the probability that the option will be “in the money” on the expiration date. The probability that an option will be either above or below the strike price on or before expiration, requires several variables as well as an option pricing model. The Black-Scholes pricing model is the standard in the industry.

Don’t worry, you do not need to know the intricate mathematical calculations to understand how to value an option. What you do need to understand is the inputs that are used in the model. The most important inputs are the current exchange rate of the currency pair, the strike price, the expiration date, as well as the implied volatility.

What is Implied Volatility?

In the world of currency options, implied volatility is the most important component. Implied volatility tells you the market’s view of how much a currency pair will move during a specific period. Generally, implied volatility is quoted in percentage terms, like 10%, which tells you the market believes a currency pair will move 10% over the next 12 months.

Implied volatility generally reflects fear and complacency in an options market. When implied volatility is elevated, it represents fear and uncertainty. As a general rule of thumb, you want to purchase options when the implied volatility is relatively low and sell currency options when the implied volatility is elevated.

The above chart of the Euro Chicago Board of Options Exchange shows a mean index of implied volatility on the Euro versus Dollar for the average of calls and puts combined. Implied volatility over the 2-year periods reached a high of nearly 14.5% and a low of 5%. Higher levels of implied volatility generate higher premiums and a costlier option price. Options on currency futures and ETFs are generally quoted using a premium, while OTC currency options are generally quoted in terms of their implied volatility.

How are Currency Options different from Stock Options?

The pricing of a stock option is somewhat different from a currency option in that you need to incorporate a dividend if the stock pays one. Stocks often have a much higher implied volatility relative to currency options. This is mainly because stocks do not have a central bank that is trying to reduce the volatility. While there are times when implied volatility on currency options spike, most of the time, central banks are attempting to reduce volatility.

When you purchase a currency option, you also need to know the direction you are speculating on. This is obvious when you purchase an option on a future or an ETF, but not as obvious when you are buying or selling an option on an OTC currency pair. 

There is a nomenclature with OTC currency pairs that you need to know. For example, the dollar versus yen is quoted as USD/JPY while the Euro versus the US dollar is quoted as EUR/USD. If you are buying a call on the EUR/USD, you are betting that the Euro is going to rise relative to the dollar. If you are buying a call on the USD/JPY, you are speculating that the dollar will rise relative to the yen.

Summary

Currency options are options on currency pairs. The main variable that determines the value of an option is the implied volatility. When implied volatility is rich, options are expensive. When implied volatility is low, option prices are subdued. Options on currencies are like options on other assets, with some minor exceptions. Before you begin to speculate on currency options, you should become familiar with the nuances over both options trading and currency pair trading.

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