Derivatives Market size and type

The derivatives market is extremely large. It is estimated to be $1.2 quadrillion in size.

The commonly traded derivatives market is divided into two categories: OTC and exchange-based ones.

OTC, or over-the-counter derivatives, are the contracts that are not listed on exchanges and are traded directly between parties. Institutional clients, such as commercial banks, hedge funds, and government-sponsored enterprises frequently buy OTC derivatives from large institutions like investment banks.

Exchange-based derivatives, such as Futures and Future options, are the ones that are listed on public exchanges, such as the Chicago Mercantile Exchange (CME) and CBOT, NYMEX and COMEX .

Online trading of currencies

The more common derivatives used in online trading are:

• Spot FX: It enables you to speculate on the increase or decrease in prices of spot market currencies that will mirror the movements of the underlying asset, where profits or losses are continually booked as the asset moves in relation to the position the trader has taken. It is traded in a decentralised market and the market makers and brokers are free to set their own capital and margin requirements. In some cases, they even accept US$100 for trading.

• CFD FX: It is very much like spot fx. It is popular in the UK but the regulators in Hong Kong don't permit this instrument. CFD providers mainly make profits out of spreads and swap fees collected from traders for keeping positions overnight.

• OTC Currency Options give traders the right to buy or sell an underlying asset at a specified price, on or before a certain date with no obligations. The market makers have set minimum capital size as the value of a contract, but brokers can again allow retail investors to trade any size of the contract. They accept even US$250 for trading fx options.

OTC products are more flexible as the brokers accommodate small investors while the exchange-traded products maintain rigidity in terms of margin capital.

Exchange-traded products

The margin capital requirements for Futures Contracts and Futures Options contracts are fixed by the exchanges. The contracts are standardised and unlike Spot Fx instruments or OTC options, brokers can't show flexibility in terms of margin requirements.

• Currency or Fx Futures contracts are an agreement to buy or sell currencies paid for at a later stage but with a set price. Currency Futures are standardized and require minimum initial and maintenance margins fixed by regulated exchanges.

• Currency Futures Options give traders the right to buy or sell an underlying asset at a specified price, on or before a certain date with no obligations. Essentially, the Exchange acts as the counterparty in case of Currency Futures Options while OTC currency options is a bilateral agreement between the buyer and seller.

Who bears the loss when sellers default?

When options are traded on recognized exchanges such as the Chicago Mercantile Exchange, the exchange itself is the counterparty to each trade. So if sellers default due to heavy losses, the exchange must still honour its contracts with the buyers.

Option Premium Price model

It is really not necessary to understand how the pricing is done mathematically. It is sufficient to know that the option premium price is based on some combination of the difference between the current market price and the strike (future) price, the length of time until the option expires, and the probability of an exchange rate movement large enough for the option to be exercised (this is known as “implied volatility”). The smaller the difference between the current market rate and the strike price, the longer the time to maturity, and the higher the volatility, the more expensive the option may be.

How Prices are quoted: Bid/Ask Spread

The bid/ask spread is the difference in price between the buyers and sellers of any option contract. The bid is the price that a buyer is willing to pay for an option while the ask is the price that a seller is willing to pay for that same option. Bid and ask prices usually fluctuate throughout each trading day which can change the spread.

Placing orders: market or limit

You can place a "market" order if you want to buy quickly. If you think the price is not good for you, you can place a "Limit" order setting your own price.

Market orders are transactions meant to execute as quickly as possible at the present or market price. Conversely, a limit order sets the maximum or minimum price at which you are willing to buy or sell.

What does it mean to be Long and Short?

When watching a sports game, would you bet on who’s going to lose?

Essentially, “short-sellers” or Put option buyers bet that a currency will fall in price even though they don't own the currency. Long investors or Call option buyers bet that the prices will rise. Shorting is quite a strange transaction. You’re selling something you don’t own. This happens in a financial trading market. And the goal is to sell high and then buy low, as opposed to the common game plan of first buying low then selling high.

Black Swan

A black swan is an event or occurrence that is not predicted. It is like an abnormal event. Typically random and unexpected. The market crash of 2008 is such an event. Escalated Implied Volatilty forces the exchange and brokers to change margin levesl. Which means most of the margin accounts with no buffer of 80% get killed.

Contract size is fixed

Currency futures trade in one standardized contract size and so traders must trade in multiples of the contracts. For example, buying one Euro FX options contract means the trader is in actual fact holding say 125,000 Euros. Buying 10 Euro FX contacts on CME means the trader is holding 1.25 million Euros.

In-the-money Options settlement/delivery

Exchanges have different policies. Some settle in cash. Some deliver the futures the underlying .

in case of CME, it takes two steps to settle in cash when the options are delivered on expiry. First your account shows up options contracts converted as Futures since the underlying asset is Futures and not Cash.

If you want to settle by way of cash instantly, you have to first take the delivery in futures and then liquidate in the market and get cash in the underlying currency. For example, the EUR futures market is based upon the Euro to US Dollar exchange rate, and its underlying currency is Euro. When an EUR futures contract expires in the money or liquidates futures positions, the holder receives a delivery of $125,000 worth of Euros in futures account. Only after futures are liquidated, the amount is credited to cash account.

Out-of-the-money options on expiry: If the contract expires out-of-the money the buyer loses all the premium. Only the seller retains the premium which the trader had received upfront when the option contracts were sold.

Trades liquidated prior to delivery or expiry are all settled in cash only whether the options have intrinsic value, only extrinsic value or both.

When you open positions:

When you buy an option = you pay a premium ($ $) that is taken out of your account.

When you sell an option = you receive a premium ($ $) into your account

When you close positions before the expiration date of options

It is not necessary to hold the options till their expiry. You can buy or sell anytime before the expiration date.

A buyer can offset or liquidate the positions by selling in the market.

A seller can offset or liquidate the positions by buying in the market.

When the open positions expire in the money

If you have sold a call option = at expiration of time period you are short (sold) a futures contract

If you have sold a put option = at expiration of time period you are long (bought) a futures contract

Strike Price

It is a price at which the holder of an options position can buy (in the case of a call option) or sell (in the case of a put option) the underlying security when the option is exercised. Hence, the strike price is also known as exercise price.

Class, style and Expiration

A European-style call/put option places a restriction on the holder to exercise the option only on the expiration date. American-style options place no such restriction. The terms have no connection with geography. CME offers only European style options on five products: British pound, Canadian dollar, Euro FX, Japanese yen and Swiss franc futures contracts. There is no risk of early exercise with European style options, which are automatically exercised if they expire in the money. However whether it is American or European style options, the trader does not have to wait for the expiry date to liquidate the positions as long as there is liquidity in the market. Options on CME FX futures trade virtually around the clock on the its Globex electronic trading platform and it is possible to liquidate the options any time.

Moneyness

The value of an option depends on its strike price's distance and direction from the underlying market changes.

An option can be described as being in any one of three states of moneyness depending on its strike price versus the market price:

In-the-money (ITM)

• The intrinsic value of an in-the-money option is equal to the absolute value of the difference between the current price of the underlying asset and the option's strike price. or

At-the-money (ATM) : There is hardly any intrinsic value between the current price of the underlying asset and the option's strike price. Zero value. or

Out-of-the-money (OTM) : The intrinsic value of an out-of-the-money option is zero.

Unless the strike price equals the market rate, the moneyness of a Put option differs from that of a Call option:

When the strike rate of a long (buy) Put is above the market rate, we say it is in-the-money because the strike allows you to sell at a higher price.

When the strike rate of a long (buy) Call is below the market rate, we say it is in-the-money because the strike allows you to buy at a cheaper price.

When an option is in-the-money (ITM), it is more valuable, i.e. its premium is higher. ITM options are the most expensive to buy, whereas out-of-the-money (OTM) options are the cheapest.

Intrinsic value and Extrinsic Value (also known as Time Value) of In-the-money (ITM) options

Futures and Options are two different trading instruments and their prices will also be different.

Futures prices are quoted in terms of the market price.

The prices of options are affected by changes in the price of the underlying currency pair , by the passage of time and the market sentiment or the power of expectations. The technical term used for this is called Implied Volatility.

Options price is composed of two parts, one of which is intrinsic value that comes into play only when the exercise price of options is more than the market price of futures. The intrinsic value gives an idea of whether the future price of the currency is undervalued or overvalued.

In other words, intrinsic value only refers to in the money options. A negative intrinsic value would mean that the options is either at the money or out of the money.

The second part is called Extrinsic value , also known as time value. Extrinsic value is calculated as the difference between an option's market price and its intrinsic value. The buyer does not get any extrinsic value when the option expires. Time value will be zero once the option expires.

The method used to calculate intrinsic value will vary depending on the type of option that has been bought – in call options, it is the price of the underlying asset minus the strike price, whereas in put options, it is the strike price minus the price of the underlying asset.

Assuming the Euro Futures price is 1.08235 (similar to a spot price) the Strike Price of a Call is 1.08500 and the premium (ask) is 0.01390 points for the call. The price is more than the underlying price which means the call is out of the money.

The premium has no intrinsic value.

If the Euro Price is 1.08265 and the trader wants to buy the call at a strike price of 1.08000 and the premium (ask) is 0.04000, then the difference between the two is: strike price (1.08000) - the underlying price (1.08265) = 0.00135

Extrinsic value will be: 0.01350. Intrinsic value: 0.00265 when the option premium value is 0.04000.

The term intrinsic value refers to the amount of money assigned to an asset as determined through fundamental analysis. Intrinsic value can be determined by summing the discounted stream of future income derived from an asset.

Example of Put Options: If the Euro price is 1.08235 and the trader wants to buy put at a strike price 1.08100 and the premium (ask) is 0.01190 points for the put . The price is less than the underlying price which means the put is out of the money. The premium has no intrinsic value.

If the Euro Price is 1.08265 and the trader wants to buy the put at a strike price of 1.08400 and the premium (ask) is 0.03900, then the difference between the two is: strike price (1.08400) - the underlying price (1.08265) = 0.00135

Extrinsic value will be: 0.02550. Intrinsic value: 0.001350 when the option premium value is 0.03900.

The intrinsic value of any out-of-the-money options , be it a put or call, is zero.

How can you settle Futures options and get cash?

For trading Exchange-traded Future Currency Options, the actual physical transaction of the currency pair is not required and you do not have to exercise the option to receive your profit until the expiry.

Instead of settling ITM options with cash, you will first get delivery of futures. If needed, you can then liquidate futures for a cash settlement.

Instead, the running profit or loss of the option position is calculated for you and when you close the option trade, or it expires OTM, cash is credited to your free balance (if the option has premium value).

Trades can be closed any time before expiry (during trading hours) to lock-in profit or reduce a loss.

Very rarely a trader takes delivery of the currency futures for speculating further in the Futures Market on the movement of the currencies. Over 95% of options transactions are closed out with an offsetting sale or purchase of the same option, or options expire without any remaining value.

Front Month and Back month

A front month refers to the contract month with an expiration date closest to the current date. The front month is sometimes called nearby month, nearest month, or spot month. The delivery date for the underlying futures may be very closer.

Contracts that have later expiration dates than the front month contracts are called the back month contracts.

The front month contracts are considered to be most liquid and usually, they have the smallest spread between the future price and spot price.

Rolling

A trade is said to be rolled when the timeline is extended for a losing position to recover. Rolling a trade involves closing the existing position and replacing it with a new one. It is part of risk management exercise and helps gain time for the trade to become favourable.

The rollover, or “the roll”, is a critical juncture in which a trader decides to move the position from the soon-to-expire front month contract to a deferred contract by simultaneously offsetting the nearby position and establishing a like position in a contract further in the future, known as back month contract.

Option Spread strategy

A spread consists of opening two opposite positions to hedge against risk. An options strategy typically involving two options on the same, single underlying asset. This is part of techniques to transfer or distribute risk.

Open Interest (OI) is no secret

This is a new Futures and Options market (not OTC) term, which is in addition to Volume term that confuses most of the beginners.

1 open interest = 1 NEW contract opened by a seller when there is a buyer.

1 open interest = 1 old contract remains if the buyer later sells the option. In other words the contract is transferred.

-1 open interest = 1 OLD contract is closed by a seller when the contract is bought back. Open interest is reduced

How volume differs from Open Interest?

1 volume = 1 contract traded ( any time during the day). If 100 Open Interest transactions (mere transfers between the buyer and sellers) are there the volume become 100. It counts even a transfer as an addition to the volume.

Why is this new term Open Interest introduced?

Futures and options are not issued by a central source, like stock itself which is issued by the company.

Instead, they are contracts created by the investors themselves, when one offers to sell and another agrees to buy at a given price.

If the buyer later sells the option, the contract is transferred but still exists. When a seller buys back an option, the contract is taken out of existence, and Open Interest is reduced.

Open Interest term is used to denote the existence of contracts in a centralised exchange rather than in a decentralised OTC (over-the-counter) or bilateral market.

A listed option, or an exchange-traded option, is one that is offered on a national exchange such as New York Stock Exchange (NYSE) or Chicago Board of Trade (CBOT). They cover securities such as common stocks, exchange-traded funds (ETFs), market indexes, currencies, fixed income securities, and commodities.

US Securities and Exchange Commission (SEC) and US Commodities Futures Trading Commission (CFTC) oversee the regulated markets in USA including 16 listed exchanges and the Options Clearing Corporation (OCC) which acts as both the issuer and guarantor for options and futures contracts. OCC clears transactions for put and call options, stock indexes, foreign currencies, interest rate composites, and single-stock futures.

Gamma is the index of delta

Gamma is the greek that gives us a better understanding of how delta will change when the underlying moves. It is literally the rate of change of an option’s delta, given a $1.00 move in the underlying. For example, if a long call option has a gamma of 0.10 and a delta of 0.50, and the underlying moves up $1.00, the option will then have a delta of 0.60, all else equal. There are a few important concepts when it comes to gamma: Long option benefits, short option risks, and expiration risk.

Long Option Benefits of Gamma

Gamma is friendliest to long option holders. It accelerates profits for every $1.00 the underlying moves in our favor, and decelerates losses for every $1.00 the underlying moves against us. Since delta is the rate of change of an option’s price, and gamma increases an option’s delta as it moves closer to, or further in the money, in the example above the delta would just continue to increase. Every dollar the underlying increased would result in more and more efficient returns on the investor's capital. This phenomena also decelerates losses, as it works in the opposite way for every $1.00 the underlying moves against us.

Short Option Risks of Gamma

Because it can be beneficial for option buyers, that must mean that it can be risky for option sellers. From the seller’s perspective, it can accelerate losses, and decelerate directional gains. It is just the opposite side of the coin from the example above.

Expiration Risk & Gamma

The final aspect of gamma that is important to realize is expiration risk. As we get closer to expiration, our probability curve gets much more narrow. There is not a lot of time for the underlying to move to our far OTM strikes, and they will have a lower probability of being ITM because of that. Since we know the probability curve is more narrow, that also means our delta distribution is more narrow. The result is a more aggressive gamma. This can be good for option buyers, but especially bad for option sellers. It can quickly turn winning trades into losers, or losing trades into winners. We prefer to avoid these drastic swings, which is just another reason why we roll or close our positions 7-10 days prior to expiration.

Views can be expressed in different ways by both buying and selling options

Buying a CALL or PUT - risk max your premium.

Selling a CALL or PUT - risk unlimited

Call = Buy = Bullish = (+) Put=Sell=Bearish=( -) Buy a Call =(+)*(+)= (+) = Bullish Buy a Put =(+)*(-)= (-) = Bearish Sell a Call =(-)*(+) = (-)=Bearish Sell a Put =(-)*(-) = (+)=Bullish