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FX Options - I'm sure I am wrong, but don't know where exactly

  • #1
  • First Post: Jul 20, 2012 2:41pm Jul 20, 2012 2:41pm
Dear everyone,

I am absolutely new to options trading and I'd like to ask a question about something that caught my attention.

I played a bit with a broker's options platform and figured out that a long AUD/USD call with 28 days till expiration is more expensive in terms of premium than what I would receive for selling 4 AUD/USD calls on after the other, each with 7 days expiration. The 28 day long call was something like 1200 and the 7 day short call was around 400.

Obviously I am missing something here, because buying a 28 day call and selling weekly calls until the long call expires would leave me with no risk and positive premium, but I know trading does not work like this.

Could someone let me know where I have made the mistake?

Thanks guys!

Csabi
  • #2
  • Jul 20, 2012 3:14pm Jul 20, 2012 3:14pm
Just for clarification, where are you trading these options?

These aren't binary options, right?

If they are like regular options, then your risk changes a bit depending on the strike price of the option itself and the expiry.

Would need a full options quote for both contracts to explain more.
FXGears.com
  • #3
  • Jul 20, 2012 3:54pm Jul 20, 2012 3:54pm
Thanks for the answer.

No, these are not binary options, but vanilla options.

In Saxobank's online platform the AUD/USD at-the-money (1.0385) long call with an expiry of 17th Aug 2012 costs $920. At the same time, the AUD/USD at-the-money (1.0385) short call expiring on 27th July 2012 pays $370. So obviously four times the short call earns much more than the cost of the long call.

What I thought was that after the first weekly short call expires, I open the second one, then after expiry I open the third one, then later the 4th one. This way I would always have my position hedged, would I not?

Thanks,

Csabi
  • #4
  • Jul 21, 2012 12:52pm Jul 21, 2012 12:52pm
Points to note:
1. The strike of 7day ATM AUDUSD is almost always DIFFERENT at every rollover, depending on where current spot and implied vol is (at every rollover) i.e. ATM strike need not be at 1.0385 always.

2. If you look at the attached vol curve for AUDUSD, you'll notice the curve sloping gently higher across the expiry axis, reflecting the fact that the market is quoting higher vols (i.e. higher prices) for strikes maturing further into the future. This vol curve is dynamic and changes almost every time an option is transacted, therefore, you cannot expect the price of a 7-day option to remain the same at every rollover. Also, as in the spot market, you are also subject to the market maker's bid/ask spread on vols.

3. (On a slightly unrelated note, you will also see that the curve is "skewed" in favor of AUDUSD puts as opposed to AUDUSD calls i.e. the market is paying higher vols [i.e. higher prices] for Out of the Money [OTM] AUDUSD puts relative to OTM AUDUSD calls)

4. (... which is another way of saying that the FX options market is laying heavy bets that AUDUSD is overbought and is getting ready for a good sell-off later. Notice that options traders are paying good vols for puts all the way to 10-year expiries !!! )

Quoting csabz90
Thanks for the answer.

No, these are not binary options, but vanilla options.

In Saxobank's online platform the AUD/USD at-the-money (1.0385) long call with an expiry of 17th Aug 2012 costs $920. At the same time, the AUD/USD at-the-money (1.0385) short call expiring on 27th July 2012 pays $370. So obviously four times the short call earns much more than the cost of the long call.

What I thought was that after the first weekly short call expires, I open the second one, then after expiry I open the third one, then later the 4th one. This way...
Attached Image (click to enlarge)
Click to Enlarge Name: 2012_0722_001.png Size: 230 KB
I'm not trying to convince anyone. I'm not in the "convincing" business.
  • #5
  • Jul 21, 2012 1:16pm Jul 21, 2012 1:16pm
Just looked into Saxo's options products... what a good business, they make the market entirely, set the spread, and already have the existing core business in place to hedge out at nearly no cost.

Nice.

I'd really like to see a standard venue for options trading on forex. . . maybe brokers could work with an equities firm and start offering options on currency ETFs? That's not ideal though.

While Options on futures work, they aren't so liquid for most pairs.. and the size requirement would most likely mean the broker would make a market for smaller trades and have to basket order the difference.. so not a good way either. :/




Oh, skenobi pretty much covered your question.

I'd just add that if you keep doing calender spreads as you described, the cost of transaction will rise, and you gotta pick the right strike price to keep it viable...

For instance, if you by a leap so you can sell the front month premium (common strategy) but the price moves so your strike price is deep in the money, then you won't really gain much from selling premium on the front month anymore and would need to shift strikes (this adds risk if you leave it unbalanced, or just extra transactional costs if you roll the leaps as well.)

I'm not an options trader myself.. I love the concept of them and I do my best to learn everything about them I can, but a hardcore options guy might be able to add more insight here.
FXGears.com
  • #6
  • Jul 21, 2012 1:35pm Jul 21, 2012 1:35pm
Quoting Jack_Larkin
I'm not an options trader myself.. I love the concept of them and I do my best to learn everything about them I can, but a hardcore options guy might be able to add more insight here.
I used to be "hardcore" back in my interbank trading days..

But the stress of continually rebalancing the option greek risks of my options portfolio got a bit too much, hence my recent "retirement" from that part of the business.

I don't pretend to know how competitive Saxo's prices are relative to what I was used to as a former institutional player, but what I can say is this:
I doubt very much a retail trader can make consistent money making "relative value" options trades i.e. buying cheap options and selling options at a higher options price, trying to make money from the premium difference.

It's possible for interbank guys to do this, but just barely because of bid/ask spreads in option vols, and I imagine Saxo would've loaded a lot of margin in their favour to not make calendar spreads (for example) viable in the longer term.

So what Jack says is also correct: picking the right strike is key. But it's not always a worthwhile exercise. Hopefully the landscape improves and retail trader positions in FX options gets further integrated in the vol curves that currently only reflect interbank positions.
I'm not trying to convince anyone. I'm not in the "convincing" business.
  • #7
  • Jul 22, 2012 7:10am Jul 22, 2012 7:10am
Wow, thank you for the detailed answers, you made it clear for me.

Cheers!
  • #8
  • Jul 22, 2012 3:45pm Jul 22, 2012 3:45pm
I have vol surface envy Skenobi, I'm stuck in the relative dark ages with tables.

Anyway you and Jack both hit on the same thing I've had a problem with. I looked at IG's deriv offering, but similarly their pricing is completely and utterly disguised. And to add insult to injury their digitals expire at some time plucked out their ass.

So, is size the determinant of getting access to transparent/fair priced options? And who with? I don't understand why the market seems so underdeveloped relative to equities
  • #9
  • Jul 22, 2012 4:36pm Jul 22, 2012 4:36pm
Ok. Skenobi gave you a good explantion, so that should help.
When i moved from interbank spot fx to otc options, the company gave us a pretty indepth study program, to become familiar with the basics, i.e the greeks and their effect, black scholes,vol, spot implications etc.It was written by an ex trader who worked there.
Not sure if i've still got it, but i'll have a look this week, and if i find it, i'll pop back, get your deets, and will send you a copy.
  • #10
  • Jul 23, 2012 12:07am Jul 23, 2012 12:07am
Quoting triphop
I have vol surface envy Skenobi, I'm stuck in the relative dark ages with tables.
Hmm... I wouldn't get too hung up about not being able to freely access fx option vol surfaces, if I were you.

FX options is (not to put a finer point on it) no better than gambling. At least, the spot FX market is more transparent.

If you look at the AUDUSD vol surface I posted earlier, all it does is show option traders' "bets" on the future. As soon as AUD sentiment turn bullish again (and I have no doubt that it will), the skew will shift to AUD calls and the surface will tilt again.

Even if you didn't have this vol surface information at your disposal, AFAIC there's no better sentiment indicator than the slope of a simple moving average line.

And given that there are many millions of options trades (I think) that are currently "live" (not expired yet), with risk reversals, binaries, barriers etc etc having many different strikes and contract specs.... all it is is just information overload, when the options trades themselves do not even nullify standard classical technical analysis (this last bit is my opinion based on years of casual observation)

I won't discount the usefulness of knowing where barrier levels are being defended, but seriously, do you really need to know them when you can already see the support/resistance with your own eyes? :nerd:

Quoting triphop
So, is size the determinant of getting access to transparent/fair priced options? And who with? I don't understand why the market seems so underdeveloped relative to equities
The simple answer is yes. If you're not an interbank or hedge fund trader, you're not likely to get narrower spreads on options prices anywhere. As to your last question, I don't understand why myself.
I'm not trying to convince anyone. I'm not in the "convincing" business.
  • #11
  • Jul 23, 2012 3:19am Jul 23, 2012 3:19am
Quoting skenobi
And given that there are many millions of options trades (I think) that are currently "live" (not expired yet), with risk reversals, binaries, barriers etc etc having many different strikes and contract specs.... all it is is just information overload, when the options trades themselves do not even nullify standard classical technical analysis (this last bit is my opinion based on years of casual observation)

I won't discount the usefulness of knowing where barrier levels are being defended, but seriously, do you really need to know...
Don't pay much attention to barrier info, so probably not. My issue is that from time to to time, I want to sell short dated vols that are fairly, transparently priced and expire at NY cut, so either brokers are missing a trick, they think we don't notice shonky pricing and expiries, or the market's too small. Either way, it'd be helpful if they got their act together.

Quoting skenobi
Hmm... I wouldn't get too hung up about not being able to freely access fx option vol surfaces, if I were you.
I can't promise that, it's just far more visually appealing than a table. The envy remains.
  • #12
  • Edited 8:17pm Jul 23, 2012 6:16am | Edited 8:17pm
Quoting triphop
Don't pay much attention to barrier info, so probably not. My issue is that from time to to time, I want to sell short dated vols that are fairly, transparently priced and expire at NY cut, so either brokers are missing a trick, they think we don't notice shonky pricing and expiries, or the market's too small. Either way, it'd be helpful if they got their act together.
By selling short dated "vols" did you mean selling short-dated straddles? At-The-Money (ATM) straddles are usually the only packages that should be transparently priced as ATM strikes are commonly traded. If the brokers are giving you bullsh!t spreads even for ATM, I dont even know WHAT to say that.

But if you meant selling short-dated strikes in the "wings" (whether OTM or ITM), you'll be at the mercy of the market maker's vol surface.

The interbank players can shop around for the best price but retail traders probably won't have that luxury for some time.

That sucks ass, I know, but that's where we are at the moment..
I'm not trying to convince anyone. I'm not in the "convincing" business.
  • #13
  • Jul 23, 2012 11:35am Jul 23, 2012 11:35am
Quoting skenobi
By selling short dated "vols" did you mean selling short-dated straddles? At-The-Money (ATM) straddles are usually the only packages that should be transparently priced as ATM strikes are commonly traded. If the brokers are giving you BS spreads even for ATM, I dont even know WHAT to say that.

But if you meant selling short-dated strikes in the "wings" (whether OTM or ITM), you'll be at the mercy of the market maker's vol surface.

The interbank players can shop around for the best price but retail traders probably won't have that luxury...
Either ATM or in the wings. The foundations seem completely off to me. I had two main requirements -
1) to be able to sell for something in between 1d and 1w, but it's either 1d or 1w (and all european so no buying them back midweek). I know they're priced w/m/3m etc but I should be able to buy something in between a daily and a weekly right?
2) all strikes to expire at NY cut. The expiry for weekly and monthly is at NY, but the dailies is at 20:00 London.

To get around this, they have a 'custom bets' section, which has its own custom pricing engine and the current setting appears to be set to 'rip and run'.

Are my expectations off, or is this just a case of tinpot brokers?
  • #14
  • Jul 23, 2012 2:02pm Jul 23, 2012 2:02pm
Quoting triphop
Either ATM or in the wings. The foundations seem completely off to me. I had two main requirements -
1) to be able to sell for something in between 1d and 1w, but it's either 1d or 1w (and all european so no buying them back midweek). I know they're priced w/m/3m etc but I should be able to buy something in between a daily and a weekly right?
2) all strikes to expire at NY cut. The expiry for weekly and monthly is at NY, but the dailies is at 20:00 London.

[b]To get around this, they have a 'custom bets' section, which has its own custom pricing...
ive been doing lots of work on binary options and the various others offered.ive also been using ig for this purpose,the custom bets look ok ,but for what im trying to do,they are always not quite custom enough,i think custom for themselves.
.the binary options have helped serve my purpose,but having said that they really dont seem quite correctly adjusted,certainly heavly swayed towards there own greeds.

im presently looking at alternatives but keep hitting a brickwall.as retail im not sure we can get the full benifits,of which there are many.

as ive said im enjoying the binaries for one of my methods,but feel im paying to much for them and also there to rigid with the expiries,ive looked at every which way,but cant quite get what im looking for.

reminds me of a song u2
  • #15
  • Jul 23, 2012 8:01pm Jul 23, 2012 8:01pm
Hello csabz90 and others,

Great discussion and alot of good indepth technical information. I especially agree with Jack_larkin, yes, it is the perfect business model for a broker to implement. They hope traders trade more in binaries than spot.

csabz90 I believe your question has already been thoroughly answered.

My personal experience with binaries/bets/cb go back few years - Not as a retail trader.

And from my personal experience, on a clear trending days you will find they tend not to take bets. Betonmarkets and ig are infamous for this.

Im not sure if it has been changed but for custom bets ig does not display any closing out early odds and only a P/L. Im not surprised if they still dont because it is to their advantage. It does leave an opportunity for them to discreetly reduce your PL. And why not when you have no control.

Custom bets also dont have 'out of range' bet types, which would be the opposite for any traders who wishes to hedge per se. Even if the bet is available.

In my opinion, and as stated above by Skenobi, fx spot market is more transparent, even more so than stock or commodity markets. Whilst many traders complain at how fx trading is becoming a shark infested water I believe that it is better than ever to trade in fx. And many of established traders are ditching other investment vehicles to fx.

Trade well.

Lex
  • #16
  • Jul 23, 2012 8:14pm Jul 23, 2012 8:14pm
Quoting triphop
Either ATM or in the wings. The foundations seem completely off to me. I had two main requirements -
1) to be able to sell for something in between 1d and 1w, but it's either 1d or 1w (and all european so no buying them back midweek). I know they're priced w/m/3m etc but I should be able to buy something in between a daily and a weekly right?
In interbank trading, we can transact any odd dates, even "mid-anything" for European strikes. But we can always get the best price because we have more counterparties to choose from. Contract dates are not fixed like in the American exchanges.

Quoting triphop
2) all strikes to expire at NY cut. The expiry for weekly and monthly is at NY, but the dailies is at 20:00 London.

To get around this, they have a 'custom bets' section, which has its own custom pricing engine and the current setting appears to be set to 'rip and run'.

Are my expectations off, or is this just a case of tinpot brokers?
Hmm.. I don't think you're wrong to expect perfection as a customer, but we can't expect retail brokers taking a relative dip in fx option waters to be like a full service interdealer broker (like Tullet Prebon, ICAP etc) overnight.

We're just not "there" yet, I guess.
I'm not trying to convince anyone. I'm not in the "convincing" business.
  • #17
  • Jul 24, 2012 3:32am Jul 24, 2012 3:32am
Thanks Sken and others.

No we're definitely not there! For me, the whole area outside spot is red flagged for now. Weekly and monthly puts and calls approach reality but that's about it.

Good game being a retail broker. Package up the risk you're going to offset, mark it up and sell it back to your client base at inflated prices. Reduce your operating costs and increase your trade turnover in one.

Anyway, sticking to spot...
  • #18
  • Jul 25, 2012 7:12am Jul 25, 2012 7:12am
I think options are more suited to hedging longer term investments than outright speculation, particularly for us retailers and the prices we are quoted.

Also options have a very close relationship with forwards, which have a very close relationship to spot. So as a retailer, I can't find any real benefits to speculating on options when the costs are so much lower trading spot.

You also have to consider time value of options and other complexities that make it much harder for us little folk to compete with top banks with their teams of highly paid mathmaticians and analysts, continuously repricing and reassessing the market 24/7.

I'll probably reconsider options as I start trading longer term but at this stage I'm thinking only of trying to master spot.
  • #19
  • Jul 25, 2012 5:21pm Jul 25, 2012 5:21pm
The Black-Scholes Formula
In this section we will use some Ito calculus ideas to give a derivation of the celebrated
Black-Scholes formula of finance. You financial insiders will notice that I have adhered to
the unspoken rule of attaching the obligatory modifier “celebrated” to the hallowed formula.
Yes, indeed it is celebrated. I’d give it a 98; it has a good beat, and you can hope to make
a lot of money from it.
The problem addressed by the formula is determining how much an “option” should
cost. We’ll talk about “call” options. A call option on a certain stock is the right to buy a
share of the stock at a certain fixed price (the “strike price”) at a certain fixed time in the
future (the “maturity date”). If I buy a call option from you, I am paying you a certain
amount of money in return for the right to force you to sell me a share of the stock, if
I want it, at the strike price on the maturity date. Our problem is, what is the “right”
amount of money for me to pay for this right?
The meaning of the term “right” here relates to the economic term arbitrage. An
arbitrage opportunity is the opportunity to make money instantly and without risk. That
is, you get some money for sure, right now. Such free lunches are not supposed to exist, or at
least should be rare and short-lived. The basic reason for believing this is that many people
are looking for such opportunities to make money. If the price of commodity A were so
low, for example, that some clever financial transaction involving buying commodity A and
perhaps selling some others were guaranteed to make an instantaneous profit, then many
eager arbitrage seekers would try to perform the transaction many times. The resulting
increased demand for commodity A would cause its price to increase, thereby destroying
the arbitrage opportunity.
Let the stock price at time t be X(t). Let t1 denote the maturity date, and k, the strike
price of the option. A little thought shows that the value of the option at time t1 is the
random variable (X(t1) − k)+, since it makes sense for me to “exercise” the option if and
only if X(t1) > k. Let Y (t) denote the magic, no-arbitrage price for the option that we
are seeking. Assume that Y (t) may be expressed as some function f(X(t), t) of X(t) and
t; our goal is to determine the function f. As a final assumption, let the “interest rate” or
the “riskless rate of return” be r; that is, $1 in a riskless investment today becomes $ert at
time t.
Stocks and options are risky investments; they are not like banks, because we do not
know how much we will be able to get back at any future time. We assume a simple probabilistic
model for the evolution of the stock price: suppose X is the geometric Brownian
motion having stochastic differential
dX = μX dt + σX dW.
Thus, X is the exponential of a Brownian motion with drift. It is comforting that this process
will not become negative. Indeed, in accordance with our view of Brownian motions
as the stochastic analog of linear functions, geometric Brownian motion seems like a sensible
first model: riskless investments change as exp(linear function), and stocks change as
exp(Brownian motion). What we are really assuming is that returns, that is, proportional
changes in the stock price, are stationary and independent over different time intervals.
Stochastic Processes
  • #20
  • Jul 25, 2012 5:24pm Jul 25, 2012 5:24pm
A key idea behind the Black-Scholes formula is that by trading both the stock and the
option simultaneously, we can reduce our risk. If we just buy a call option, we will be
happy if the stock price goes up and sad if it goes down. What can we do with the stock to
restore ourselves to blissful equanimity, in which we are indifferent whether the stock price
goes up or down? We need to do something that will make us sad if the stock goes up and
happy if it goes down. Selling some stock will do the trick!
Thus, let us consider the portfolio: “buy one call, sell A shares of stock, and put the
rest of our money in a bond.” The price of the bond is assumed to follow the riskless form
ert. Our investing strategy consists of two stochastic processes: at time t we hold A = A(t)
shares of stock and B = B(t) “shares” of bond, where A and B are assumed to be adapted
stochastic processes. The value of this portfolio at time t is
(6.31) V (t) = Y (t) − A(t)X(t) + B(t)ert.
We say that the strategy (A,B) is self-financing if X(t) dA(t) = ert dB(t) for all t. The
interpretation of this is: our trades of the stock and bond neither remove money from the
portfolio nor require adding additional money from the outside. The changes dA(t) and
dB(t) we make in our holdings just reallocate the money in the portfolio, without adding or
removing money. This relationship between the processes A and B says that the proceeds
X(t) dA(t) from the sale of stock at time t are precisely offset by the cost ert dB(t) of the
stock purchases made at time t. [[These changes could be positive or negative; if they are
negative we are buying stock and selling bonds at time t, and we are using the money from
the bond sales to buy the stock.]] Any gains or losses in the value of the portfolio then must
come from changes in the prices of the assets, not from our changing of our allocations A(t)
or B(t).
From the expression for V (t) we have
dV (t) = dY (t) − A(t) dX(t) − X(t) dA(t) + B(t)rert dt + ert dB(t).
The self-financing condition causes two of the terms to cancel, leaving
(6.32) dV (t) = dY (t) − A(t) dX(t) + B(t)rert dt.
With our assumption that Y (t) = f(X(t), t), Ito’s formula gives
dY = fx(X, t)dX + ft(X, t)dt + (1/2)fxxσ2X2 dt.
Therefore,
(6.33) dV = [fx(X, t) − A(t)]dX(t) + [ft(X, t) + (1/2)fxxσ2X2 + B(t)rert]dt.
There is an obvious choice that looks interesting: Suppose we adopt the strategy A(t) =
fx(X(t), t)—we can conceive of doing this, even though we do not happen to know what f
is yet. Observe that the differential dV then would have no dX part, just a dt part, and,
by (6.31),
B(t)rert = r[V (t) − Y (t) + A(t)X(t)] = rV (t) − rf(X, t) + rX(t)fx(X(t), t).
Stochastic Processes
6.10. THE BLACK-SCHOLES FORMULA
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