Exchange Traded Currency Options: Comprehensive Course Notes (Part 2)
1. Option Greeks
Option Greeks are quantitative measures that describe how different market variables affect the price or value of an option contract. They help traders and risk managers measure portfolio sensitivities.
The Four Core Option Greeks
| Greek | What It Measures | Formula |
|---|---|---|
| Delta (Δ) | Sensitivity of option price to changes in the underlying asset's price | Delta = Change in Option Price / Change in Price of Underlying Asset |
| Vega (ν) | Sensitivity of option value to changes in volatility | Vega = Change in Option Value / Change in Volatility of Underlying Asset |
| Theta (Θ) | Sensitivity of option value to the passage of time (time decay) | Theta = Change in Option Value / Passage of Time |
| Rho (ρ) | Sensitivity of option value to changes in the risk-free interest rate | Rho = Change in Option Value / Change in Risk-Free Rate |
2. Option Pricing Methodologies
There are two primary models used in financial markets to calculate the theoretical value of currency options.
Comparison of Pricing Models
| Feature | Black and Scholes Model | Binomial Pricing Model |
|---|---|---|
| Primary Design | Analytical methodology. | Computational methodology. |
| Execution Speed | Faster to compute. | Requires more computing power. |
| Primary Application | Mainly used to price European options. | Mainly used to price American options. |
3. Option Payoffs and Settlement Rules
The return generated from an options strategy relative to changes in the spot price of the underlying currency is referred to as the payoff.
Non-Linear Payoffs
Unlike futures, which have linear risk profiles, option strategies result in non-linear payoffs. This means the payoff profile is represented by a curved line or a line with a sharp bend. This unique structure is a direct result of optionality—the buyer's right to walk away from the contract without any obligation to execute.
The Four Vanilla Options Positions
Vanilla options represent the basic building blocks of any option-trading portfolio:
- Long Call: Buying a call option to benefit from upward price movements.
- Short Call: Selling/writing a call option to collect premium, expecting stable or falling prices.
- Long Put: Buying a put option to benefit from downward price movements.
- Short Put: Selling/writing a put option to collect premium, expecting stable or rising prices.
Final Settlement Rule
For all exchange-traded currency option contracts in India, the final settlement does not involve physical delivery of the currencies. Instead, final settlement is completed in cash based on the RBI reference rate on the date of expiration.
4. Currency Option Trading and Combination Strategies
Combination strategies involve the simultaneous execution of multiple option contracts using the same or different strike prices and expiration dates. These are structured to target specific market views, risk tolerances, and investment objectives.
Classification of Option Strategies by Market Outlook
A. Moderately Bullish or Bearish Outlook
These strategies are used when a trader expects a moderate movement in the exchange rate of a currency pair.
- Bull Call Spread
- Bull Put Spread
- Bear Put Spread
- Bear Call Spread
B. Range-Bound (Low Volatility) or Breakout (High Volatility) Outlook
These strategies are deployed when the trader expects the USDINR or another currency pair to remain within a tight range, or conversely, break out sharply in either direction.
- Short Strangle
- Short Straddle
- Long Butterfly
C. Strong Breakout (High Volatility) Outlook
These strategies are specifically structured to profit from major, sharp exchange rate movements where direction may be unknown, but high volatility is anticipated.
- Long Straddle
- Short Butterfly
5. Risk-Mitigation Strategies Complimenting Futures Positions
Options can be combined with existing positions in the currency futures market to hedge risks, protect gains, or generate supplementary income.
Key Combined Hedging Structures
- Covered Call: Writing a call option against an existing long asset or long futures position to generate yield from premium collection when the market is flat.
- Covered Put: Writing a put option against an existing short position.
- Protective Call: Buying a call option to protect an existing short futures position against adverse upward price movements.
- Protective Put: Buying a put option to protect an existing long futures position against adverse downward price moves.