How Currency Options are Traded

The OTC options market has become a 24-hour market,much like the spot and forward markets, and has developed its own practices and conventions. Virtually all of the major foreign exchange dealer institutions participate as market makers and traders.

They try to stay fully abreast of developments, running global options books that they may pass from one major center to another every eight hours, moving in and out of various positions in different markets as opportunities arise. Some major dealers offer options on large numbers of currency pairs (fifty or more), and are flexible in tailoring amounts and maturities (from same day to several years ahead).

They can provide a wide array of different structures and features to meet customer wishes. A professional in the OTC interbank options market asking another professional for a quote must specify more parameters than when asking for, say, a spot quote.

The currency pair, the type of option, the strike price, the expiration date, and the face amount must be indicated. Dealers can do business with each other directly, by telephone or (increasingly) via electronic dealing system, which makes possible a two-way recorded conversation on a computer screen.

Also, they can deal through an OTC (voice) broker. Among these dealers and brokers, quotes are presented in terms of the implied volatility of the option being traded.

As in other foreign exchange markets, a market maker is expected to give both a bid the volatility at which he is prepared to buy an option of the specified features and an offer the volatility at which he is prepared to sell such an option.

For example, an interbank dealer, Jack from Bank X, might contact a market maker, Jill from Bank Z, identify himself and his institution and ask for a quote:

• w Jack: “Three month 50-delta dollar
• put/yen call on 20 dollars, please.”
• Jill: “14.50-15.”
• w Jack: “Yours at 14.50.”
• Jill: “Done. I buy European three-month
• 50-delta dollar put/yen call on 20 dollars.”

After this commitment to the trade, details (“deets”) would then be worked out and agreed upon with respect to the exact expiration date, the precise spot rate, the exact strike price, and option premium. Customarily, in trades between dealers, there would be an offsetting transaction in spot or forward trade, in the opposite direction to the option, to provide both parties with the initial delta hedge.

Note that Jack and Jill specified both currencies—“dollar put/yen call.” In foreign exchange options, since a call allowing you to buy yen for dollars at a certain price is also a put allowing you to sell dollars for yen at that price, it helps to avoid confusion if both formulations are mentioned.