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MECHANICS OF FX OPTIONS ON NSE

Anindya Banerjee
Anindya Banerjee

This document provides an overview of currency options and strategies for trading them. It discusses factors that affect currency prices, introduces basic option concepts, and explores strategies for profiting from volatility, directional bets, and ranged markets. These strategies include straddles, strangles, spreads, and arbitrage opportunities. The document also discusses option Greeks and how they relate to money-ness, time to expiration, and volatility.

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PROGRAMME ON CURRENCY OPTIONS by 17-Aug-10 Anindya Banerjee
CONTENTS What drives USD/INR. Introduction to FX options. Volatility and trading of volatility Options for directional trading Options for ranged markets. Arbitrage in NSE FX options. Neutralise directional bias Option sensitivity
Factors affecting USD/INR Long term factors: Current Account situation and Capital account flows.
Factors affecting USD/INR Short-term Factors: - Stock market. - Risk aversion to emerging markets. - Inter-relationship between USDINR and other Asian currencies. - Inter-relationship between USDINR and global major currencies. - RBI intervention.
MECHANICS OF FX OPTIONS ON NSE
INTRODUCTION Option basics: Call & Put option, European option, strike price, money-ness or likelihood of expiring in the money, expiry date, delivery date, futures price. Option price /premium = Intrinsic value (tangible)+ extrinsic value (expected). USD/INR call option of August 2010, strike 46, trading @ 0.58 INR. Forward rate is 46.37. Option premium (0.58) = Intrinsic Value (0.37)+ Extrinsic Value (0.21). Factors that drive an option price: Price of USD/INR, Time to expiration, Volatility, Interest rate differential, Intrinsic Value. Buyer bets on small probability of large move, Seller bets on large probability of small move
GARMAN KOHLHAGEN MODEL 1. The distribution of terminal currency exchange rate (returns) is lognormal. 2. There are no arbitrage possibilities. 3. Transactions cost and taxes are zero. 4. The risk-free interest rates, the foreign interest rates, and the exchange rate volatility are known functions of time over the life of the option. 5. There are no penalties for short sales of currencies. 6. The market operates continuously and the exchange rates follows a continuous Ito process.
PROFITING FROM VOLATILITY involves figuring out whether or not the price will hit the Strike, and in how much time
ON VOLATILITY Volatility = Sudden-ness + Size of currency movements. Two types of Volatility: Historical and Implied Historicals are calculated statistically from historical prices Exist largely in theory, seldom used in practice. Lagging indicator Implieds are back-calculated from the prevailing option prices and fed back to get new prices. Are leading indicator, reflect markets anticipation of future movement. 20 53 20 Correlation between Spot and Vols Correlation between Spot and Vols 53 Close correlation between Spot 52 18 18 51 52 (underlying) and Vols. 16 51 16 50 14 3M Vol 3M Vol USDINR Close 49 50 Vols fall alongwith fall in Spot 14 USDINR Close 49 12 12 48 48 Vols rise alongwith rise in Spot 47 10 47 8 10 46 46 Falls in Spot have been gradual. 45 8 www.kshitij.com www.kshitij.com 45 Rise in Spot has been sudden. This 6 44 is reflected in the Volatility. 23-Dec-08 28-Jan-09 25-Feb-09 26-Mar-09 25-May-09 23-Jun-09 21-Jul-09 19-Oct-09 17-Nov-09 15-Dec-09 15-Jan-10 16-Feb-10 19-Mar-10 19-May-10 17-Jun-10 15-Jul-10 6 44 18-Sep-09 23-Apr-09 19-Aug-09 20-Apr-10 13-Aug-10 23-Dec-08 28-Jan-09 25-Feb-09 26-Mar-09 25-May-09 23-Jun-09 21-Jul-09 19-Oct-09 17-Nov-09 15-Dec-09 15-Jan-10 16-Feb-10 19-Mar-10 19-May-10 17-Jun-10 15-Jul-10 18-Sep-09 23-Apr-09 19-Aug-09 20-Apr-10 13-Aug-10
MAKING MONEY FROM VOLS BASIC Buy / Sell Call / Put Strike I/A/O Cost Buy Call 46.34 ATM 3796 Buy Put 46.34 ATM 3796 Total Cost 7592 Underlying View Volatile, in either directon Max Risk Limited to Cost paid Max Return Limited after a point Characteristic 2 legged option Name Straddle
MAKING MONEY FROM VOLS INTERMEDIATE Buy / Sell Call / Put Strike I/A/O Cost Buy Call 46.34 ATM 3796 Buy Call 46.8 OTM 2102 Sell Call 46.00 ITM -5684 Total cost 214 Underlying View Volatile with an upward bias Max Risk Limited Max Return Unlimited on the upside Characteristic leveraged Name Short Call Ladder
PROFITING FROM DIRECTIONAL BETS Hoping your view is right, not really losing if it is not!
PROFITING FROM DIRECTIONAL BETS BASIC Buy / Sell Call / Put Strike I/A/O Cost Buy Call 46.34 ATM 3796 Underlying View Bullish on USDINR Max Risk Limited to Cost paid Max Return Unlimited Characteristic One single option Name As Plain Vanilla as they come
PROFITING FROM DIRECTIONAL BETS INTERMEDIATE Buy / Sell Call / Put Strike I/A/O Cost Buy Call 46.34 ATM 3796 Sell Call 47.34 OTM -559 Total Cost 3237 Underlying View Bullish, but only upto a point Max Risk Limited to Cost paid Max Return Limited after a point Characteristic 2 legged option Name Bull Spread
PROFITING FROM DIRECTIONAL BETS ADVANCED Buy / Sell Call / Put Strike I/A/O Cost Sell Put 46.50 ITM -4165 Buy Put 46.00 OTM 4628 Total Cost 463 Underlying View Large downmove. Max Risk Limited Max Return Unlimited on the downside Characteristic Leveraged, 1X2 Name Put Back Spread
PROFITING FROM RANGED MARKETS Make money when no one else can
PROFITING IN RANGED MARKETS
PROFITING IN RANGED MARKETS BASIC Buy / Sell Call / Put Strike I/A/O Cost Sell Call 47.00 OTM -1014 Sell Put 45.68 OTM -970 Total Cost -1984 Underlying View Ranged market Max Risk Unlimited Max Return Limited to premium collected Characteristic 2 legged option Name Strangle
PROFITING IN RANGED MARKETS INTERMEDIATE Buy / Sell Call / Put Strike I/A/O Cost Sell Call 46.40 OTM -3289 Buy Call 46.75 OTM 2145 Sell Put 46.00 OTM -1891 Buy Put 45.50 OTM 1072 Total cost -1963 Underlying View Ranged market Max Risk large but limited Max Return Limited to premium collected Characteristic 4 Legged option Name Iron Condor
PROFITING IN RANGED MARKETS ADVANCED Buy / Sell Call / Put Strike I/A/O Cost Buy Call 46.00 ITM 5684 Sell Call 46.76 OTM -1671 Sell Call 46.76 OTM -1671 Total cost 2342 Underlying View Ranged with bearish bias Max Risk Unlimited Max Return More than premium collected Characteristic leveraged 1x2 Name Call Ratio Spread
ARBITRAGE: RISKLESS PROFITS Arbitrage relates to taking advantage of mis-pricing in USD/INR options. Frequency of mis-pricing is high in markets where liquidity is still not abundant. Even liquid option markets like NSE equity options do exhibit mis-pricing from time to time. How to capitalise on mis-pricing of options? - Triangle strategy: based on put-call parity. Triangle strategy: Suppose USD/INR 46.00 Aug Call is quoting 0.64. USD/INR 46.00 Aug Put is quoting 0.24 USD/INR Futures for Aug is quoting 46.34 Difference between Call and Put premium = INR 0.40 No arbitrage spread level = (46.34-46.00)= INR 0.34 Risk-less profit = INR ((0.40-0.34)*1,000,000)= INR 60,000. Trade: Sell 46 Aug Call, buy 46 Aug Put, Buy USD/INR futures. Qty= 1 million USD.
ARBITRAGE: RISKLESS PROFITS Box Spread: Bull-bear spread trade. Box spread strategy: Suppose USD/INR 46.00 Aug Call is quoting 0.40 USD/INR 46.50 Aug call is quoting 0.20 USD/INR Futures for Aug is quoting 46 USD/INR 46.00 Aug Put is quoting 0.38 USD/INR 46.5 Aug Put is quoting 0.78 Cost of a bull spread 46/46.5 = INR 0.2 Cost of bear spread 46/46.5 = INR 0.4 Total cost of the bull and bear spread = INR 0.6 No arbitrage cost should have been = (46.5-46.00)= INR 0.5 Risk-less profit = INR ((0.6-0.5)*1,000,000)= INR 1,00,000. Trade: Sell 46 Aug Call, buy 46.5 Aug call, Buy 46 Aug put and sell 46.5 Aug put Qty= 1 million USD.
CAN I MAKE MONEY WITHOUT BETTING ON DIRECTION? How to be neutral on direction? Delta is change in Option Price Hedge the delta on your option portfolio. due to change in Spot. It is not exactly, but is taken to be the chance of the Option expiring In the Money How to hedge delta of option portfolio? Portfolio: Long 10 contracts of 46 August put @ 2062.56. Delta = (-) USD 3540. In order to neutralise delta, we have to buy 3540 USD @ 46.20. Post delta hedging the option portfolio is for the moment would not be affected from a upward or downward movement in the USD/INR. When do we make our portfolio delta neutral? - When we are looking to trade other Greeks viz., Gamma, Theta, Vega. - Want to minimize directional impact on portfolio. Option gives us the flexibility of making money without having to always bet on market direction.
OPTION GREEKS What are option Greeks? Option Greeks are set of factor sensitivities used for measuring risk exposures related to options. Delta, Gamma, Theta, Vega, Rho.
KEY INTER-RELATIONS BETWEEN GREEKS Delta vs. money-ness (ATM, ITM or OTM) : In the money options (ITM) have higher delta than out of the money options (OTM). Gamma, Vega & theta vs. money-ness : At the money options have the highest Gamma, Theta and Vega. All three decline as the option moves in or out of money. Gamma vs. Time : Gamma increases as time to expiry declines. Theta vs. Time : Theta increases as time to expiry declines. Vega vs. Time : Vega decreases as time to expiry declines. Delta vs. Volatility: Delta of an ITM declines and OTM increases.
http://montegodata.co.uk/Consult/Garman/garman.htm
PROGRAMME ON CURRENCY OPTIONS by 17-Aug-10 Thank You! www.kshitij.com info@kshitij.com 033-24892010 /12

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MECHANICS OF FX OPTIONS ON NSE

  • 1. PROGRAMME ON CURRENCY OPTIONS by 17-Aug-10 Anindya Banerjee
  • 2. CONTENTS What drives USD/INR. Introduction to FX options. Volatility and trading of volatility Options for directional trading Options for ranged markets. Arbitrage in NSE FX options. Neutralise directional bias Option sensitivity
  • 3. Factors affecting USD/INR Long term factors: Current Account situation and Capital account flows.
  • 4. Factors affecting USD/INR Short-term Factors: - Stock market. - Risk aversion to emerging markets. - Inter-relationship between USDINR and other Asian currencies. - Inter-relationship between USDINR and global major currencies. - RBI intervention.
  • 6. INTRODUCTION Option basics: Call & Put option, European option, strike price, money-ness or likelihood of expiring in the money, expiry date, delivery date, futures price. Option price /premium = Intrinsic value (tangible)+ extrinsic value (expected). USD/INR call option of August 2010, strike 46, trading @ 0.58 INR. Forward rate is 46.37. Option premium (0.58) = Intrinsic Value (0.37)+ Extrinsic Value (0.21). Factors that drive an option price: Price of USD/INR, Time to expiration, Volatility, Interest rate differential, Intrinsic Value. Buyer bets on small probability of large move, Seller bets on large probability of small move
  • 7. GARMAN KOHLHAGEN MODEL 1. The distribution of terminal currency exchange rate (returns) is lognormal. 2. There are no arbitrage possibilities. 3. Transactions cost and taxes are zero. 4. The risk-free interest rates, the foreign interest rates, and the exchange rate volatility are known functions of time over the life of the option. 5. There are no penalties for short sales of currencies. 6. The market operates continuously and the exchange rates follows a continuous Ito process.
  • 8. PROFITING FROM VOLATILITY involves figuring out whether or not the price will hit the Strike, and in how much time
  • 9. ON VOLATILITY Volatility = Sudden-ness + Size of currency movements. Two types of Volatility: Historical and Implied Historicals are calculated statistically from historical prices Exist largely in theory, seldom used in practice. Lagging indicator Implieds are back-calculated from the prevailing option prices and fed back to get new prices. Are leading indicator, reflect markets anticipation of future movement. 20 53 20 Correlation between Spot and Vols Correlation between Spot and Vols 53 Close correlation between Spot 52 18 18 51 52 (underlying) and Vols. 16 51 16 50 14 3M Vol 3M Vol USDINR Close 49 50 Vols fall alongwith fall in Spot 14 USDINR Close 49 12 12 48 48 Vols rise alongwith rise in Spot 47 10 47 8 10 46 46 Falls in Spot have been gradual. 45 8 www.kshitij.com www.kshitij.com 45 Rise in Spot has been sudden. This 6 44 is reflected in the Volatility. 23-Dec-08 28-Jan-09 25-Feb-09 26-Mar-09 25-May-09 23-Jun-09 21-Jul-09 19-Oct-09 17-Nov-09 15-Dec-09 15-Jan-10 16-Feb-10 19-Mar-10 19-May-10 17-Jun-10 15-Jul-10 6 44 18-Sep-09 23-Apr-09 19-Aug-09 20-Apr-10 13-Aug-10 23-Dec-08 28-Jan-09 25-Feb-09 26-Mar-09 25-May-09 23-Jun-09 21-Jul-09 19-Oct-09 17-Nov-09 15-Dec-09 15-Jan-10 16-Feb-10 19-Mar-10 19-May-10 17-Jun-10 15-Jul-10 18-Sep-09 23-Apr-09 19-Aug-09 20-Apr-10 13-Aug-10
  • 10. MAKING MONEY FROM VOLS BASIC Buy / Sell Call / Put Strike I/A/O Cost Buy Call 46.34 ATM 3796 Buy Put 46.34 ATM 3796 Total Cost 7592 Underlying View Volatile, in either directon Max Risk Limited to Cost paid Max Return Limited after a point Characteristic 2 legged option Name Straddle
  • 11. MAKING MONEY FROM VOLS INTERMEDIATE Buy / Sell Call / Put Strike I/A/O Cost Buy Call 46.34 ATM 3796 Buy Call 46.8 OTM 2102 Sell Call 46.00 ITM -5684 Total cost 214 Underlying View Volatile with an upward bias Max Risk Limited Max Return Unlimited on the upside Characteristic leveraged Name Short Call Ladder
  • 12. PROFITING FROM DIRECTIONAL BETS Hoping your view is right, not really losing if it is not!
  • 13. PROFITING FROM DIRECTIONAL BETS BASIC Buy / Sell Call / Put Strike I/A/O Cost Buy Call 46.34 ATM 3796 Underlying View Bullish on USDINR Max Risk Limited to Cost paid Max Return Unlimited Characteristic One single option Name As Plain Vanilla as they come
  • 14. PROFITING FROM DIRECTIONAL BETS INTERMEDIATE Buy / Sell Call / Put Strike I/A/O Cost Buy Call 46.34 ATM 3796 Sell Call 47.34 OTM -559 Total Cost 3237 Underlying View Bullish, but only upto a point Max Risk Limited to Cost paid Max Return Limited after a point Characteristic 2 legged option Name Bull Spread
  • 15. PROFITING FROM DIRECTIONAL BETS ADVANCED Buy / Sell Call / Put Strike I/A/O Cost Sell Put 46.50 ITM -4165 Buy Put 46.00 OTM 4628 Total Cost 463 Underlying View Large downmove. Max Risk Limited Max Return Unlimited on the downside Characteristic Leveraged, 1X2 Name Put Back Spread
  • 16. PROFITING FROM RANGED MARKETS Make money when no one else can
  • 18. PROFITING IN RANGED MARKETS BASIC Buy / Sell Call / Put Strike I/A/O Cost Sell Call 47.00 OTM -1014 Sell Put 45.68 OTM -970 Total Cost -1984 Underlying View Ranged market Max Risk Unlimited Max Return Limited to premium collected Characteristic 2 legged option Name Strangle
  • 19. PROFITING IN RANGED MARKETS INTERMEDIATE Buy / Sell Call / Put Strike I/A/O Cost Sell Call 46.40 OTM -3289 Buy Call 46.75 OTM 2145 Sell Put 46.00 OTM -1891 Buy Put 45.50 OTM 1072 Total cost -1963 Underlying View Ranged market Max Risk large but limited Max Return Limited to premium collected Characteristic 4 Legged option Name Iron Condor
  • 20. PROFITING IN RANGED MARKETS ADVANCED Buy / Sell Call / Put Strike I/A/O Cost Buy Call 46.00 ITM 5684 Sell Call 46.76 OTM -1671 Sell Call 46.76 OTM -1671 Total cost 2342 Underlying View Ranged with bearish bias Max Risk Unlimited Max Return More than premium collected Characteristic leveraged 1x2 Name Call Ratio Spread
  • 21. ARBITRAGE: RISKLESS PROFITS Arbitrage relates to taking advantage of mis-pricing in USD/INR options. Frequency of mis-pricing is high in markets where liquidity is still not abundant. Even liquid option markets like NSE equity options do exhibit mis-pricing from time to time. How to capitalise on mis-pricing of options? - Triangle strategy: based on put-call parity. Triangle strategy: Suppose USD/INR 46.00 Aug Call is quoting 0.64. USD/INR 46.00 Aug Put is quoting 0.24 USD/INR Futures for Aug is quoting 46.34 Difference between Call and Put premium = INR 0.40 No arbitrage spread level = (46.34-46.00)= INR 0.34 Risk-less profit = INR ((0.40-0.34)*1,000,000)= INR 60,000. Trade: Sell 46 Aug Call, buy 46 Aug Put, Buy USD/INR futures. Qty= 1 million USD.
  • 22. ARBITRAGE: RISKLESS PROFITS Box Spread: Bull-bear spread trade. Box spread strategy: Suppose USD/INR 46.00 Aug Call is quoting 0.40 USD/INR 46.50 Aug call is quoting 0.20 USD/INR Futures for Aug is quoting 46 USD/INR 46.00 Aug Put is quoting 0.38 USD/INR 46.5 Aug Put is quoting 0.78 Cost of a bull spread 46/46.5 = INR 0.2 Cost of bear spread 46/46.5 = INR 0.4 Total cost of the bull and bear spread = INR 0.6 No arbitrage cost should have been = (46.5-46.00)= INR 0.5 Risk-less profit = INR ((0.6-0.5)*1,000,000)= INR 1,00,000. Trade: Sell 46 Aug Call, buy 46.5 Aug call, Buy 46 Aug put and sell 46.5 Aug put Qty= 1 million USD.
  • 23. CAN I MAKE MONEY WITHOUT BETTING ON DIRECTION? How to be neutral on direction? Delta is change in Option Price Hedge the delta on your option portfolio. due to change in Spot. It is not exactly, but is taken to be the chance of the Option expiring In the Money How to hedge delta of option portfolio? Portfolio: Long 10 contracts of 46 August put @ 2062.56. Delta = (-) USD 3540. In order to neutralise delta, we have to buy 3540 USD @ 46.20. Post delta hedging the option portfolio is for the moment would not be affected from a upward or downward movement in the USD/INR. When do we make our portfolio delta neutral? - When we are looking to trade other Greeks viz., Gamma, Theta, Vega. - Want to minimize directional impact on portfolio. Option gives us the flexibility of making money without having to always bet on market direction.
  • 24. OPTION GREEKS What are option Greeks? Option Greeks are set of factor sensitivities used for measuring risk exposures related to options. Delta, Gamma, Theta, Vega, Rho.
  • 25. KEY INTER-RELATIONS BETWEEN GREEKS Delta vs. money-ness (ATM, ITM or OTM) : In the money options (ITM) have higher delta than out of the money options (OTM). Gamma, Vega & theta vs. money-ness : At the money options have the highest Gamma, Theta and Vega. All three decline as the option moves in or out of money. Gamma vs. Time : Gamma increases as time to expiry declines. Theta vs. Time : Theta increases as time to expiry declines. Vega vs. Time : Vega decreases as time to expiry declines. Delta vs. Volatility: Delta of an ITM declines and OTM increases.
  • 27. PROGRAMME ON CURRENCY OPTIONS by 17-Aug-10 Thank You! www.kshitij.com info@kshitij.com 033-24892010 /12