FX Options

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A foreign exchange option (FX option) is a derivative financial instrument where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date.

The FX options market is the deepest, largest and most liquid market for options of any kind in the world. Most of the FX option volume is traded OTC and is lightly regulated, but some volume is traded on exchanges like the International Securities Exchange(ISE), Philadelphia Stock Exchange, or the Chicago Mercantile Exchange.

The International Securities Exchange trades ISE FX Options.[1], providing instant access to a new investment strategy allowing investors to trade their views on the strength or weakness of the U.S. Dollar. All ISE FX Options have U.S. Dollar-based underlying values, which are scaled as needed to create an underlying value similar to traditional equity or index options.

For example, if the current USD/EUR rate is .6750 (0.6750 EUR per 1 USD), the underlying value for the ISE Euro FX Option would be 67.50. This format allows investors to easily adopt the trading strategies they currently use for equity and index options. ISE FX Options are cash-settled, which eliminates the need for investors to hold the actual foreign currency. Using this approach, investors will recognize that U.S. Dollar-strength is exhibited when a rate increases, and U.S. Dollar-weakness when a rate decreases.

ISE currently trades the following currency pairs:

Currency Name Currency Code Convention Symbol
Australian dollar AUD USD/AUD AUX
British pound GBP USD/GBP BPX
Canadian dollar CAD USD/CAD CDD
Euro EUR USD/EUR EUI
Swiss franc CHF USD/CHF SFC
Japanese Yen JPY USD/JPY YUK

ISE also provides a widget that shows latest exchange rates for each currency pair. The application can be downloaded to a Web page or Google homepage.

Settlement

Cash settlement for FX options eliminates the need to hold the actual foreign currency, making the process much more straight forward. Investors can actually trade out of their positions until expiration Friday, which is the third Friday of the expiration month at 12 p.m. (New York Time). ISE FX Options will settle at 12 p.m. (New York Time), at the Federal Reserve Bank of New York published “Noon Buying Rates”. Following are some examples:

Long Options

  • If the option is in-the-money at expiration, the investor receives cash (holder’s position)
  • Example: 100 call, ISE pair value closes at 104, the investor receives 104-100 or $4 *100 or $400 per contract
  • Example: 100 put ISE pair value closes at 96, the investor receives 100-96= of $4 *100 or $400 per contract
  • If the option is out-of-the-money at expiration the investor receives nothing (holder’s position)

Short Options

  • If the option is in-the-money at expiration the investor pays cash (writer’s position) (See above)
  • If the option is out-of-the-money at expiration, the option expires worthless

Benefits

With exchange-listed options, investors get full price transparency. Displayed prices and quote sizes are always actionable and counterparty credit risk is almost entirely eliminated, since FX Options are issued and cleared through the Options Clearing Corporation (OCC). Standardization within the exchange space has also created tremendous liquidity. FX options allow investors to implement their forecasts for months ahead, with limited risk compared to spot FX trading.

References

  1. ISE FX Options. ISE.