CME Group’s Exchanges have offered options exercisable for currency futures dating back to 1982. Like the Exchange’s family of currency futures products, these options may be used as an effective and efficient tool to manage currency or FX risks in an uncertain world.
The purchase of an option implies limited risk and unlimited potential reward. The sale of an option implies limited reward and unlimited risk.
This post is intended to provide an overview of the mechanics of options on currency futures. Note that options contemplate the establishment of a currency futures position. These contracts are accessible through the CME Globex electronic trading platform.
What is an Option?
Options provide a very flexible structure that may be tailor made to meet the risk management or speculative needs of the moment. Options may generally be categorized as two types: calls and puts … with two very different risk/reward scenarios.
Two Types of Options
Call options convey the right, but not the obligation, to buy a specified quantity currency at a particular strike or exercise price on or before an expiration date. One may either buy a call option, paying a negotiated price or premium to the seller, writer or grantor of the call; or, sell, write or grant a call, thereby receiving that premium.
Buying a call is a bullish transaction; selling a call is bearish.
Put options convey the right, but not the obligation, to sell a specified quantity currency at a particular strike or exercise price on or before an expiration date. Again, one may buy or sell a put option, either paying or receiving a negotiated premium or price.
European-style vs American-style
Options may be configured as European- or American-style options. A European-style option may only be exercised on its expiration date while an American-style option may be exercised at any time up to and including the expiration date.
Profit/Loss for Call Option
The purchase of a call option is an essentially bullish transaction with limited downside risk. If the market should advance above the strike price, the call is considered “in-the-money” and one may exercise the call by purchasing currency at the exercise price even when the exchange rate exceeds the exercise price. This implies a profit that is diminished only by the premium paid up front to secure the option. If the market should decline below the strike price, the option is considered “out-of-the-money” and may expire, leaving the buyer with a loss limited to the premium.
Option buyers pay a premium to option sellers to compensate them for assuming these asymmetrical risks.
The risks and potential rewards, which accrue to the call seller or writer, are opposite that of the call buyer. If the option should expire out-of-the-money, the writer retains the premium and counts it as profit. If, the market should advance, the call writer is faced with the prospect of being forced to sell currency when the exchange rate is much higher, such losses cushioned to the extent of the premium received upon option sale.
Profit/Loss for Put Option
The purchase of a put option is essentially a bearish transaction with limited downside risk. If the market should decline below the strike price, the put is in-the-money and one may exercise the put by selling currency at the exercise price even when the exchange rate is less the exercise price. If the market should advance above the strike price, the option is out-of-the-money, implying a loss equal to the premium.
Buying a put is a bearish transaction while selling a put is a bullish transaction.
The risks and potential rewards, which accrue to the put writer, are opposite that of the put buyer. If the option should expire out-ofthe-money, the writer retains the premium and counts it as profit. If, the market should advance, the put writer is faced with the prospect of being forced to buy currency when the exchange rate is much lower, such losses cushioned to the extent of the premium received upon option sale.
Read more about “Option Pricing”
Posted in CME Group, FX, Strategy Tagged with: Futures, FX, Options, Risk Management
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