Understanding Options Prices in Forex Trading
- In This Quick Guide:
- Strike Price
- Time Value
- Volatility
- The Expiry or the Expiration Date
- The Strike or Exercise Price
Foreign exchange (forex) trading can be puzzling, especially when it comes to options prices (also called premiums). The price of an option is a function of where the underlying financial product is in relation to the strike price, the amount of time left before the option expires, and the volatility of the underlying financial product. Don’t know what those terms mean? Read on.
Strike Price
The biggest factor in determining the price of a forex option is where the underlying currency pair is in relation to the strike price. A call option with a strike price below the current price of the currency pair has intrinsic value.
When trading forex options, the intrinsic value as it relates to forex trading is the difference, if any, between the market price of the underlying currency pair and the strike price of the option. A call option has intrinsic value if its strike price is below the price of the currency pair. A put option has intrinsic value if the strike price is above the current underlying price for the currency pair. Any option that has intrinsic value is said to be in-the-money. As a general rule, the premium paid for an option will be higher, depending on the amount of intrinsic value that the option has.
If an option has no intrinsic value, it is said to be either at-the-money or out-of-the-money. An at-the-money option is one where the underlying price for the currency pair is equal to the strike price of the option. If a call option has a strike price higher than the current price for the currency pair, the option is said to be out-of-the-money. If a put option has a strike price below the current price for the currency pair, the put option is said to be out-of-the-money. At-the-money and out-of-the-money options have what is known as extrinsic value or time value.
Time Value
The second major component of an option price—or premium—is time value. Time value is the amount of money that option buyers are willing to pay for an option in the anticipation that the price of the underlying financial product will change in value over time, causing the option to increase in value. Time value also reflects the amount of money that a seller of an option requires to give up the right to the purchaser.
Generally speaking, the time value of an option depends on the amount of time until an option’s expiration: the longer the amount of time, the greater the time value of the option will be. This is because the right to buy or sell something is more valuable to a market participant if they have several months to decide what to do than if they only have several days. Conversely, the option seller has more risk over time that the option will go in-the-money (or stay in-the-money) and thus demands more premium in exchange for selling the right to buy or sell over a longer period of time.
You can look for some parallels between options and insurance policies. For example, the premium charged for term casualty insurance increases as the policy period increases. That’s because it’s more likely the policy holder will make a claim on the policy over time. Therefore, the policy writer (the insurance company) takes on greater risk and charges a higher premium.
The same general principle applies to options: the longer the time to expiration, the greater the likelihood that the option will be exercised. So the writer of the option takes on more risk and charges a higher premium.
Options with a longer time frame generally carry a higher premium, because the trader has more time for the market to work in his or her favor. As the option gets closer to its expiration date, the time value drops because there’s less time in the option. This is called time decay.
Changes in volatility also cause changes to the option premium. Let’s take a closer look at how volatility impacts premiums.
Volatility
Another component of extrinsic value—or time value—is the volatility of the underlying currency pair. Volatility is the amount of movement in the underlying market over a period of time. Obviously, if prices are jumping up and down by large amounts, the risk and potential reward associated with this market is greater, and hence the price of the option is greater.
Volatility and time to expiration have tremendous impact on the price of out-of-the-money and at-the-money options. These factors also affect the extrinsic value portion of an in-the-money option as well. Just because an option is in-the-money does not mean that it doesn’t have any extrinsic value. But as an option gets deeper and deeper in-the-money, it loses time value as a component of its pricing.
Because options have extrinsic value, or time value, they are decaying assets. As time passes, the amount of time value decreases. The rate of decay of time value increases as you get closer to expiration, speeding way up close to six weeks until expiration. Hence, for the option purchaser, time is the enemy, slowly eroding the value of an option.
So how does all this translate into forex options? Remember that a forex option is a contract for the right to buy or sell a currency pair at a specific price on a particular date. That means that after you select a currency pair and determine if you want a call or put, you’ll specify the expiration date and strike price.
The Expiry or the Expiration Date
This is the date in the option contract when you buy or sell the currency pair at a specific price. In our EUR/USD option example, the expiry for that option was March 21.
Although you can open or close an option position at any time, your choices will be based on the time periods set by your broker or the options contract. For example, GFT (co-author Gary Tilkin’s company) offers expiries ranging from one week to up to six months. The expiry at GFT will usually occur on Wednesdays at 10 a.m. ET. If Wednesday is not an eligible trade day because of a holiday or other event, expirations will be moved to 10 a.m. ET the first available day prior to Wednesday.
GFT offers European-style options, so they cannot be exercised before they expire. If you want the right to exercise your option at any time before the expiration date, you need to find a broker that offers American-style options.
The Strike or Exercise Price
This is the specific price in the option contract that your buy or sell forex position would be opened at on the expiry if your option had value on the expiry. For example, in the EUR/USD option we talked about earlier, the strike price was 1.3500.
When you want to trade an option, your broker may offer you a range of fixed strike prices. Or you may be able to choose your own strike. The number of available strikes is usually based on a reasonable range of anticipated prices in the underlying market.
To buy the option, you’ll pay the option price or premium. When you view a list of options, you’ll notice that the value of the premium varies from option to option. That’s because many factors have an impact on the price of an option: the price of the underlying currency pair, interest rates, volatility, the strike price, and the amount of time until expiration. These are used to calculate the premium.
The difference between the strike price of your option and the current price of the underlying market is called the intrinsic value, as we discussed earlier. Here are the key points you need to remember about intrinsic value when trading forex options:
In-the-money
Call: strike price is below current price for currency pair.
Put: strike price is above current price for currency pair.
At-the-Money
Strike price equals current price for currency pair.
Out-of-the-Money
Call: strike price is above current price for currency pair.
Put: strike price is below current price for currency pair.
Foreign currency trading can be tricky, but now that you know about option pricing, you have the tools to make it work for you. Good luck!
From The Complete Idiot’s Guide to Foreign Currency Trading, Second Edition, by Gary Tilkin and Lita Epstein, MBA
