ForexLive Education: Option contracts, their impact and how to trade off them

Author: Mike Paterson | Category: Education

Here we explain again what forex option contracts are and how to use the info 16 Nov

In the wake of today's reported EURUSD barrier option interest and defence of 1.0700, along with some readers questions, here's a few answers/explanations.

Barrier options -

For those unfamiliar this is type of option whose payoff depends on whether or not the underlying asset has reached or exceeded a predetermined price. A barrier option can be a knock-out, meaning it can expire worthless if the underlying exceeds a certain price, limiting profits for the holder but limiting losses for the writer. It can also be a knock-in, meaning it has no value until the underlying reaches a certain price.

A DNT (Double No Touch) is an option that gives the trader an agreed-upon pay out if the price of the currency pair does not reach or surpass one of two predetermined barrier levels. Traders pays a premium and in turn receives the right to choose the position of the barriers, the time to expiration, and the pay-out to be received if the price fails to breach either barrier. With this type of option, the maximum possible loss is just the cost of setting up the option

Once either side (barrier) is hit then the option ceases and the writer wins.

The giant Panda, aka Peoples Bank of China, have been notable users of these contacts over the years and given the size of them, will defend a level rigorously. In recent times we have seen EURUSD barriers mostly put in on in a range of 1.0550-1.1350 with additional interest in between but these options can be traded in other pairs too of course. Today we have barrier option interest at 110.00 on USDJPY.

Barrier options are used particularly around times of great volatility such as the Grexit turbulence, Brexit, and US elections. Where we know the levels we will highlight them in the daily order boards.

In today's EURUSD 1.0700 barrier option example we saw a successful defence producing a rally but failing to make headway above 1.0730 and eventually being breached as general USD demand prevailed.

As a rule we can expect these levels ( bids or offers) to hold first time round and therefore buying/selling into these levels will invariably bring some reward

Vanilla options -

My daily posts refer to these that expire each day at 14.00 GMT. A financial instrument that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price, within a given time frame.

 A vanilla option is a normal "call" ( The buyer of the call option has the right, but not the obligation, to buy an agreed quantity of a particular commodity or financial instrument from the seller of the option at a certain time for a certain price. The seller is obligated to sell the commodity or financial instrument to the buyer if the buyer so decides. The buyer pays a fee for this right ) or "put" ( gives the owner of a put the right, but not the obligation, to sell an asset, at a specified price ) option that has standardized terms and no special or unusual features. It is generally traded on an exchange such as the Chicago Board Options Exchange.

This means that the contract will still be "live"/in play until expiry time which is generally designated at 10.00 am NY ( 15.00 GMT) each week day. This is different to a " barrier" option which is "dead" once breached.

If the prevailing price is close, say 30-50 pips away, and the expiry is large ( $750m + but smaller in less liquid pairs) we can often see the price affected/magnetized as battle ensues from both buyer and seller. We don't see the details of whether it's a "put" or "call" but the price action leading up to the event is what we're really looking for.

There is no precise science to this and any impact will largely depend on the prevailing market sentiment, but yes we can sometimes see a sharp reveral leading into the expiry only to resume previous trend after.

I cover options, orders, flows and liquidity in our online training courses that have proved very successful in the past 18 months. Keep your eyes peeled for the next one where you'll be able to spend 2 hours in a webinar with me and have the opportunity to answer questions.

I hope this has helped your general understanding of how these instruments can impact on flows and therefore hopefully add another weapon to your FX trading armoury.