The Interbank Fx Options Market - Why you Should Care
EURUSD 1.2300 strike expiry today rumored for good size ....
....says the news headline, but how do you interpret this ? To understand fx options it is best to explain some of the conventions that all professional option traders know but is not necessarily, written down anywhere. The aim of this article is to level the playing field somewhat for the retail trader by discussing common procedures in the interbank fx options market.
Majority of the fx option flow is OTC (Over-the-counter), which basically means that it is independent of any exchanges. While terms can be individual, in order to maintain liquidity there are a number of standardized conventions. Still, these conventions vary from currency pair to currency pair.
If you know a little about fx options, you have probably heard about NY cut-off which is 10AM New-York time. This is when almost all fx options are expired, especially for majors, but there are a few exceptions.
If you trade emerging market currencies you should know that for TRY, the cut-off is 12:00 London time, while for PLN it is 11:00 Warsaw time (normally 10 LDN), while for HUF it is 12:00 Budapest time (normally 11 LDN). If you trade asian emergings then Tokyo cut is also quite frequent which is 1500 Tokyo cut (GMT+9). When you are trading JPY and its crosses with American or European banks, 95% of the cutoffs would be NY though. Out of the other lesser traded European currencies NOK, SEK, CZK and ZAR pairs use NY cut-off as well, although the option market is rather illiquid. For RUB and BRL the market is mainly focused for offshore cash-settlement against a pre-defined fix and as such these pairs have to be considered separately for their behaviour.
Another thing you should keep your eye on is daylight savings time. While DST is largely standardized across Europe, the US often has a couple weeks of difference. As such if you live in London and got used to that NY cut is usually 3pm London time (as NY is GMT-5). There will be the occasional time where you will have to watch out of DST timing difference and this will shift the NY cut to be 2pm in London.
What happens at the cut-off ?
OTC options in the inter-bank market are of the European and deliverable flavour which means that they can be exercised on the day of the expiry only and if exercised the counterparties execute a spot transaction at the strike. Furthermore, despite the fact that it is called NY cut, the actual process of exercising the options are usually done by London trading centers for most of the major banks as London still remains the main fx trading center due to its access for both early morning US trading hours as well as late Asian times. As the cut-off time approaches at 14:57pm in London, the banks with the long option position call their counterpart on Reuters dealing terminals to say whether they want to exercise their long options or not.
Lets take an example. Suppose LongBank is long an EURUSD call at strike 1.2300 for 100mio with counterparty ShortBank who has the reverse position. At 14:59:55 the spot market is trading 1.2307. If the trader is delta-hedged conservatively that means that before the option expires he is long 50mio EURUSD above 1.2300 and short 50mio below. So if just before expiry he exercises the call by buying 100mio at 1.2300 from ShortBank, he can immediately close down his position by selling 50mio at 1.2307 in the spot market. At the same time ShortBank is likely has the opposite position if hedged conservatively and everything is reversed.
So why can option expiries cause the occasional sudden move in the market ? In the above example the main assumption was that the both the option holder and the counterpart have hedged their position conservatively. This completely changes if one counterparty has options for speculative reasons. A customer, like a hedge-fund, does not necessarily want to hedge their exposure in the spot market, but rather they are looking to put an exposure on by using options. The said customer could for example trade with 3 banks in 200mio each putting on the same position. At the time of expiry the market makers would need to cover a spot position of 100mio each in a short amount of time in order to make them delta-neutral causing a classical break-out in shorter time-frames. Larger speculative flow often appears on the CME group option exchanges. For speculators that want to remain completely anonymous, this is often the only route to build a large position.
Also quite often the ISM economic numbers often coincides with NY cut causing further volatility and uncertainty.
At-the-money volatility as an indicator
Other than adjusting to the swings of the market, currency specific volatility data should replace VIX for most macro oriented traders. The negative correlation between stocks and VIX has been well known and similarly for most currency pairs there is a risk-on / risk-off parallel that can be drawn, especially for most emerging economies. While at-the-money volatility numbers for the short term indicate the implied speed of the spot movements, which is usually faster and more sudden in risk-off environments, risk-reversals (or skew) signify the strength of the correlation between the speed and the direction of the market.
So if one day you see a long-term breakout in both currency volatility and the spot, you may have to adjust your intra-day trading to take into account of that the long-term trend is now strongly dominated. AUD is a typical risk-currency that trades such way. One common trading setup is when after a substantial down-move and spike in volatility for AUDUSD over a period of weeks/months, further drops do not cause higher volatility and sometimes implied volatility may even decline, signalling that the move is losing steam and a turn-around could be around the corner.
Finally volatility should also feed into most system or rule trading where take-profits and stop-losses are defined as fixed target. When volatility increases to double, it makes sense to adjust these limit orders accordingly, strengthening the system by adapting it to current and implied future market conditions. This will help you even when going into a quiet holiday season as well over Christmas as market volatility drops markedly or when volatility suddenly jumps like at the flash-crash as implied volatilities will tell you exactly by how much you are expected to modify your orders.
To sum up, for the savy trader, option market data could
provide more than just an additional dimension for trading. However the order
of complexity is much higher as one needs to take account day-light-savings
times, economic releases, holidays and speculative flow. While this
does not make a difference every single day, but there are a handful of
times in a year, where the additional knowledge can create outlier profits
making their month or even their year. Finally, if you trade a system or rule-set with fixed limit order distances then you would be well suited to adapt it by considering the current implied market volatility.
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