FX options are an integral part of the Forex market. Understanding the effect of option levels on the movement of currency pairs can help traders both avoid unnecessary losses and make additional profits. Let’s understand how this works.
The option (Latin optio – choice) is a derivative financial instrument whereby the option buyer acquires the right, but not the obligation, to buy or sell the underlying asset at a predetermined price at a future specified time. In this case, the seller of the option is obligated to make a return sale or purchase of the underlying asset in accordance with the terms of the sold option.
The option can be to buy or sell a basic asset.
Call option is an option to buy. Grants the option buyer the right to buy the underlying asset at a fixed price.
Put option is an option to sell. Grants the option buyer the right to sell the underlying asset at a fixed price.
With options, there are four options for transactions:
• buy call option
• write (sell) call option
• buy put option
• write (sell) put option
When concluding an option contract, the buyer of the option pays the seller a premium, which is essentially a payment for the right to conclude a transaction on the underlying asset in the future.
We are interested in options, where the underlying asset is a particular currency – FX-options, where the buyer of the option has the right for a certain date to exchange one currency for another according to the exchange rate agreed in advance in the conditions of the option. FX-options are mainly used for speculative purposes, as well as for the purpose of hedging export-import transactions against changes in the exchange rate compared to the rate provided for in the foreign trade contract. The use of options to hedge foreign exchange risks allows international corporations to reduce the level of currency risk to the amount of the premium for the option.
There are many types of options contracts, but the main one is the “standard option” or the other name “plain vanilla option”. The term “vanilla” is derived from the use of vanilla as the flavor for the most common ice cream and means “readily available”, “simple” or “ordinary”, Vanilla options – are traded on the exchange and all their terms (currency type, contract volume, expiration date) standardized.
Expiration of options – date and time of completion of the circulation of options contracts.
The main exchange trading center for currency options is the Chicago Mercantile Exchange (CME), the expiration time for options is standardized and occurs every day at 15:00 GMT (18:00 Moscow time in winter). It is not forgotten that in Europe and the USA they transfer hours for winter and summer time for 1 hour.
Let’s look at an example.
The current rate of EURUSD is 1.1900. You expect that within a week it will rise above 1.1950 and buy the Call option at strike price 1.1950, paying a premium for this contract, say 10 points. In order to make money on this transaction, it is necessary that the EURUSD exchange rate exceeds 1.1960 (strike price + premium paid) The option seller accordingly calculates that the rate will not rise above 1.1950 and he will earn his 10-point premium. If the rate rises, say to 1.2000, the option seller will be obliged to execute the contract and sell you EUR at the strike price – 1.1950. By selling EUR at the current exchange rate of 1.2000, you will earn 40 points with the bonus paid (1.2000-1.1950-0.0010). At the same time, if the rate falls below 1.1950 you will lose only 10 points paid. Remember, the option for the buyer is only the right, and not the obligation to execute the option contract. Thus, the buyer’s risks are limited to the option premium.
So how does all this affect the spot Forex market? Everything is very simple. Participants in both the forex market and the options market are for the most part large banks and financial organizations – they are market makers of the FX market. In the event that a large bank sold Call options for amounts in excess of one billion US dollars, and the rate of this currency went up and exceeded the strike on options, then this bank will receive large losses from the obligation to execute option contracts at a price much lower than the market price. On the other hand, if a large bank bought Call options for a large amount by paying only a premium and the rate significantly exceeded the option strike, it would receive a significant return on the exercise of options. As a result, for the optional levels, the fight in the Forex market is unfolding – the Call options seller is trying to lower the rate to the strike level in order to minimize its losses, and the buyer of the options is trying to keep the rate from the decline in order to increase or protect its income from exercising options. Optional levels become support-resistance levels or optional barriers to Forex, as they are protected by parties to options contracts.
As a rule, the strongest option levels arise on options, the expiration date of which falls on the last days of the month or the last months of the quarters.
Option levels do not always have a clear impact on the forex market, but sometimes, especially in low liquidity conditions, the struggle for an option level can become the main driver of the currency pair movement within a day.
Let’s see how it happens.
November 30, 2017 (the end of the month !!!!) for the Canadian dollar ended an option contract with a strike price of 1.2850 for a total of 1.38 billion USD, which is a very significant amount for options on the Canadian dollar. We do not know whether this is a Call or Put option. Let me remind you, the expiration time is 15-00 GMT (18-00 – Moscow).
The optional barrier at 1.2850 is marked on the graph with a blue line. The USDCAD currency pair was in the upward movement for a week. November 30, 2017 the first half of the day the pair also actively grew, but at 12-30 GMT it turned sharply and began to decline. The decline ended after reaching an optional barrier and bargaining for half an hour, USDCAD also quickly returned to its previous level. Let’s look at the minutes.
The first downward momentum ended at 1.28540 at 14-36 at point 1 on the chart. Bargaining at this level USDCAD in 14-59 !!!!!!!! reaches 1.28505 at point 2 on the chart. The price does not reach the option level of 5 pips at the time of expiration of the option contract.
How to use it on Forex.
Option levels often provide an explanation for the causeless movements of currency pairs. If you know that an optional level is located below or above the current price and there is an impulse in this direction in the absence of other drivers, you can open the corresponding positions. In this case, the optional level will act as your goal. Since option levels often act as support-resistance levels and the price often “sticks” to them, you can trade from them. At the same time, you know exactly the time when the movement may start – the expiration time is 15-00 GMT.
Watch for the publication of optional levels, including on the main page of this site. Such situations arise on Forex with enviable constancy and their understanding is appropriate to use in any trading strategy.
Another example of the effect of optional levels on the pair – FX options hold EURUSD.
Be prudent, observe risk management and trade in a plus.