In addition to FOREX liquidity pools and OTC with your broker, currency options are also traded on exchanges. Take a look at the list below of brokers who offer online access to the currency option market. I would say that there are two types of risk present when trading foreign exchange options: counter party risk and market risk.
In terms of market risk, FX options are more sensitive to macroeconomic factors than stock or futures options. The forward price used for the currency option is a combination of both interest rates in each country. More recent than the Black and Scholes is the Garman and Kohlhagen currency option pricing model. Given that currency volatility is, on average, almost half that of an equity index, you could assume that option premiums are relatively half as cheap also.
However, FOREX markets are known for their intra day price swings, so perhaps this volatility will drive up option premiums beyond their historical values. Note: The spreadsheet uses the Black and Scholes method (for European options) whereas the currency options priced are American style exercise but I don't imagine a huge difference there.
If you love selling naked options or taking on covered calls, then higher option premiums mean more credit to you when you establish the trade. In addition to options that have their underlying as foreign currency, option traders may also trade options where the underlying is a currency future.
Like all options, when you buy an option your risk is limited to the premium paid for the derivative. Buying futures contracts also requires the deposit of an "initial margin" upfront that can be much larger than an option premium, which fluctuates on a variety of factors.
This spreadsheet using for performs volume reservoir and gas reserve, volume reservoir and gas reserve calculator spreadsheet include Z factor for the formulas. FX options are call or put options that give the buyer the right (not the obligation) to buy (call) or sell (put) a currency pair at the agreed strike price on the stated expiration date. However, currency options are now very popular amounst retail investors as electronic trading and market access is now so widely available.
Many of the options traded via these firms are still considered OTC as the trader (customer) transacts directly with the broker, rather than matching the order with another trader. For example, the PHLX (NASDAQ) and the CME both offer currency options on currency futures. Like an equity option, currency options can be priced using a standard black and scholes option model with a dividend yield. For some reason, I always assumed that FOREX pairs would have higher volatility than, say, index options. I calculated both 30 day and 100 day historical volatility and then averaged this across all data sets.
I decided to use the option prices on FOREX futures listed on the CME - CME AUD Contract Specs - and plug those into my spreadsheet option calculator.
It all depends on your trading style.Volatility is factored into the time value of the option. However, when you short an option, your broker allocates a portion of your account as a margin for the position. That is, a futures contract where the underlying is based on the foreign currency.Options on currency futures are far more accessible than straight out FOREX options.
Options also carry the "right" to take delivery (exercise) of the underlying asset if so desired. The initial margin also earns interest whereas an option premium doesn't - the option premium is paid to the seller, who earns the interest on the amount paid.
I was curious about why currency options are mainly defined on currency forwards instead of currency spots. In this case the broker becomes the counter party to the currency option and hence has to wear the risk. Stock options on the other hand, while still affected by macro economic conditions, are also influenced by company specific variables such as earnings reports, downgrades, sector sentiment etc.
With a currency option, the dividend yield represents the foreign currency's continually compounded risk-free interest rate. As the FOREX market moves in response to changing interest rates so does the option premiums whose underlying asset is foreign currency. As mentioned earlier, most of the volume traded through currency options takes place in the over the counter market (OTC market), whereas options on currency futures are traded on exchanges that can be easily accessed by an online broker.
Counterparty risk is more present in currency options than stock or futures options because there is no central clearing house to protect option traders when the dealer is unable to meet the exercise obligations.
If you're strategy is buying options for directional trades, then higher vols make this more expensive and your profit per trade less. When pricing foreign currency options the interest rates of both countries need to be considered and entered into an option pricing model - unlike other types of options, such as equity options, futures options etc that only take one input for interest rates to derive a theoretical price.
The Chicago Mercantile Exchange has the most widely available currency futures and currency options in the world.
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