How Options affect FX Spot

1. How to complicate things

Delta, Gamma and volatility (“vols”) are concepts that are familiar to all options traders...but not to spot traders. However, the sheer volume of options transactions in the FX markets makes it worthwhile to understand options, at least a little bit. We will be keeping things as simple as possible – evidently because we are not trading options and only need to concentrate on those aspects that can help paint a more comprehensive picture of the market.

To be precise, we will be talking about Volatility, Market Pin Risk and the most common option structures in the FX market. But first, we need to introduce some option basics.

2. What is an Option?

An Option, in it's most basic form, is a “right” to buy or sell something. A Call Option on the Euro is the right (but not the obligation) to buy Euros, at a specific date (expiry date), at a specific price (strike price). A Put option is the right (but not the obligation) to sell Euros at a specific date (expiry date) at a specific price (strike price).

Options can of course be bought or sold. The option buyer pays a price (premium) to receive the option because he is buying the right to buy (call) or sell (put) the underlying (Euros in our example) and thus has to pay for this right. The option seller (writer) gets paid the premium and is thus exposed to the risk of exercise (the option buyer may decide to exercize his right to buy or sell the underlying, which is taken or given to the option seller).

Charting the payoff of a Plain Vanilla Call and Put, with the various Deltas per each price.

Source: FX Traders Magazine

3. Introducing Delta

In the above diagram, we have illustrated the payoff (profit/loss) for a Plain Vanilla Call and Put. Looking at how the price of the option reacts to movements in spot, we can see that call options appreciate when spot rises, whereas put options depreciate when spot rises. This is the foundation of the convention that delta is positive for calls and negative for puts. However, the change in the option price is not the same for the same spot move across the curve. This is visually illustrated by drawing tangent lines to the price curve of the option. The slope of the tangent tells us how much the price of the option moves with respect to the underlying, per each movement in spot.

Delta = the Change in Option Value / Change in the Underlying

The Option Delta has various practical interpretations, which make it easier for market participants to exchange information about it.

a) Delta = Volatility of the Option, which is also dependant on the Volatility of the Underlying.

b) Delta = Hedge Ratio. Here is a simple example. If OFT stock is worth 100 USD/share, and we own 100 Options of OFT shares at 20% Delta, then

+ 1USD in OFT shares = + 20 cents in the value of a Call option * 100 = USD 20

+ 1USD in OFT shares = - 20 cents in the value of a Put option * 100 = USD -20

So the Delta tells us how much we need to hedge (i.e. Sell in the underlying if we own calls or buy in the underlying if we own put) so that Option position P/L = Spot P/L.

c) Delta = Probability of expiring In The Money (ITM). Option prices can be seen as a representation of the market's expectation of the future distribution of spot prices. The Delta of an option can be thought of roughly as the probability of the option finishing in the money (which would benefit the option holder, or buyer). For example, given a one-month OFT call option with a strike price of 104 and a delta of 50, the probability of OFT finishing above 104 one month from now would be approximately 50%.

The picture below represents the expiries of large Plain Vanilla options, and the data is supplied by DTCC (http://www.dtcc.com/) and elaborated by Reuters Eikon/Xenith. 

FX Option Bubble chart: the larger the bubble, the larger the expiry at that price.

Data: DTCC/Eikon

The large bubbles, which we report on the weekly option calendar, represent Pin Risk:

large vanilla clusters that can exhert attraction if price is close to the strike at maturity. This is important because a large expiry will require more delta-hedging, and other players will be aware of these dynamics and may decide to “play the range” around the expiry.

Example of large expiries in the second week of November 2014 on AudUsd

Source: FXCM Marketscope

Pin Risk, like in the above example, is the risk that the option expires at or close to the strike rate. Primarily this is a risk for traders who are short the options (so the option writes, which are usually investment banks) because the trader doesn't know whether he will be exercized – assigned the underlying – or not. The option is At The Money (ATM) and Delta is 50% so there is a big question mark on the trader's head. And since these are big expiries, the risk is very tangible, and the trader must do something about it! What they do is Delta Hedge around the strike.

Who wins vs who loses depending where spot is, at expiry.

So what happens is that there is usually buying below the strike and selling above the strike. This makes price “sticky”. Various banks will be net short puts or net short calls, and various market players will be net long calls or net long puts...and this just makes it easy for the spot price to gravitate around the expiry. If a couple of conditions are met:

a) there cannot be strong sentiment during the expiry day. Option expiries have maximum effect when there are no evident flows going through the pipes on the day of expiry.

b) price must be “close”, i.e. 30/50 pips away, in order to gravitate towards the strike rate.

Unless these 2 conditions are met, spot traders can ignore the plain vanilla option expiries and their Pin Risk.

4. Introducing Volatility

Understanding FX vols is actually simple. Option volatilities measure the rate and magnitude of the changes in a currency's price. Know this: FX options are quoted in volatility. This means that higher vols from day to day mean that there is demand for that specific pair. Falling vols means that there is less demand for that specific pair. Obviously this is useful to the spot trader because if short term vols are rising, there is evident demand for the currency and there can be stronger flows and larger moves in the short term. Vice versa, if vols are dropping off, then there is a lack of demand for the currency in the short term, and trying to trade it may give birth to a slow grinding position.

At the Money (ATM) vols. Source: Tradingfloor.com

But that's not all! If short-term option volatilities are significantly lower than long-term volatilities, the market is “coiling” and sooner or later, there will be a reversal in this volatility trend – strong directional moves. Vice-versa: if short-term option volatilities are significantly higher than long-term volatilities, expect a reversion to range trading.

Typically in range-trading scenarios, option volatilities are low or declining because in periods of range trading, there tends to be minimal movement. When option volatilities take a sharp dive, it can be a good signal for an upcoming trading opportunity. This is very important for both range and breakout traders.

These guidelines generally hold up to inspection, but traders also have to be careful. Volatilities can have long downward trends (like in 2013) during which time volatilities can be misleading. Traders need to look for sharp movements in volatilities, not gradual moves.

5. Most Common Exotic Options in FX

We hear a lot of talk about “Barrier Options” in FX, so it's about time we understand them! Barrier options are part of the Exotic Digital Option Family. Exotic, because the payoff CAN be more complex than simple “plain vanilla” options; Digital, because the option can only have 2 outcomes and thus is much easier to understand (and to value) than a normal “plain vanilla” option.

Of course there are also Exotic Options that are NOT digital in nature. Here are the payoff charts of Knock-In, Reverse Knock in, Knock Out and Reverse Knock out options, with a barrier that “knocks” in or out of profit the option buyer. These are not digital, and that makes them more expensive and less utilized in the FX markets. However, they ARE used and they do have an active Barrier which can influence the spot market so we are going to briefly take a look at them.

Source: FX Trader Magazine

The knock-in option functions by being worthless unless the barrier is touched, in which case it converts into a normal vanilla option. The reverse knock in is used if the barrier is placed where the option is in-the-money (see Figure 3 and 4 above). Notice that holding a knock-in and knock-out based on the same barrier and vanilla option strike is the same as holding the vanilla option itself. Therefore, the price of holding a knock-in and a knock-out with the same barrier and strike should be equal to the price of the vanilla option with the same strike. It should now be obvious that the prices of the knock-in and knock-out options are expected to be lower than the vanilla option with the same strike. In this way, a purchaser of an exotic option may strive essentially to gain the same exposure to a vanilla option but at a lower price - on the condition that his prediction about whether the underlying will reach the barrier level holds true.

The knock-out option, instead, functions by being an ordinary vanilla option, put or call, unless a pre-specified barrier level is reached, or touched, before expiry. The option is termed reverse if the barrier is placed where the option is in-the-money. That is, if the barrier is above the strike for a call option or the barrier is below the strike for a put option. (see figures 1 and 2 below).

Source: FX Trader Magazine

The bottom line is that Exotic Barrier options (NON-digital) are suited for directional plays because they give the same payoff as the plain vanilla call or put, but cost less. However, the volatility component of these options is totally different from that of plain vanilla options so they are more difficult to hedge. And with options, it's best to keep thing simple...

..so let's introduce the more common Exotic Digital Barrier options: touch options!

Source: FX Trader Magazine

They function like bets by paying a predetermined amount if a certain condition is met. The payoff is thus the full amount or nothing, which gives rise to the term digital. The one-touch option pays out if the price of the underlying touches the barrier before expiry (see Figure 5 above). The no-touch option works the other way around and pays out if the price of the underlying does not touch the barrier before expiry (see Figure 6 above). The double-no-touch option pays out if the price of the underlying stays within a range not touching either the lower or the upper barrier of this range before expiry (see figure 7 below).

Source: FX Trader Magazine

The caveat to the above is that being out of the Interbank loop, we really don't know what kind of barrier we might be bumping up against. The DTCC/Eikon view only shows Plain Vanilla options for US counterparts – so already there you can imagine how much information is not represented. But what makes matters worse is that it does not represent the Exotic Options. For example, we are currently seeing an explosive move in the UsdJpy based on various sentiment influences that are not important for this article.

UsdJpy Daily Chart – FXCM MarketScope

Now that we've seen what spot (the underlying) has been doing, let's take a look at the DTCC/EIKON chart to see the bigger plain vanilla expiries!

 UsdJpy Bubble chart – DTCC/EIKON

How can this happen? There are basically NO expiries above market, and a LOT of expiries below market! Does this mean the Option analysis is useless? Not at all...it just shows what happens during strong trends and fast moves. What this is showing is that the market is certainly NOT covered for further gains yet in vanilla options, but it may be positioned via exotic structures such as Reverse Knock In and One Touch options – which do not show up on the DTCC/Eikon view.

So how do we know they are there? Well, we get them from market contacts that we have established; but there is also a rule of thumb to follow: of the market has not touched a round number (like 1.2000, 1.2100, 1.2200 etc.) for over 1 month, then there is probably a barrier at that level.

And now for the important take-away: how and why does the barrier affect the spot rate?

A bank owning a barrier above market in UsdJpy in the example above (let's say 117.00 which is a very realistic example), will receive a large payout if the barrier is not touched. So it will act to defend the barrier. How will it do this?

a) the bank will look to sell spot just ahead of the barrier, and will look to buy it back a little lower – so it can use the profits made to re-load on the next barrier attack.

b) the bank will sell options with higher strikes higher strikes (above 117.00) and, with the premium received, sell spot in order to defend the barrier;

c) the bank will sell volatility (via delta-hedged option structures which we will not cover here) and use the proceedings to sell spot.

But, like in a current situation, if the market is running on strong sentiment, barriers will be breached and the stops/position closing that follows will accelerate the move.

To sum up: Option trading can and does influence the spot market. This can happen around big vanilla expiries (Pin Risk through delta hedging) or option barriers (via barrier protection). Option markets also help identify good trading conditions via volatility (vols bought rather than sold, and if there has been a big change between short term and long term vols). With Options, it's always best to keep things simple so in the Skype chat room, I'll try to give you the main take-away. However, you can also decide to do this analysis on your own by getting a Reuters Eikon/Metastock Xenith subscription and access the SDR view for a hands-on approach!

Good Luck!

I would like to thank Richard Pace, the options guru of Reuters IFR for helping out with this article.