FX Options: An Alternative Way to Trade FX

It has been over six months since the COVID-19 pandemic hit the global economy and sent financial markets into one of the wildest rides ever seen. Extreme market volatility was seen across all markets with unprecedented markets dislocations. With the Fed’s intervention, by announcing QE Infinity in March, financial markets has since embarked on a dramatic turnaround. Gold and Nasdaq both hit all-time highs, while yields dropped to rock bottom. The FX market also went on a roller coaster ride. The DXY Dollar-index made a big reversal since its near 9% spike in March mainly driven the Fed’s relief measures, the eurozone’s agreement to a EUR 750 billion pandemic fund, and the escalation of the COVID-19 spread in the US. 

Despite the rosy picture painted by the financial markets, we are still facing a lot of uncertainties in the coming months. We still do not know if the global economy is able to turn around from the near knockout blow. Key risk events ‒ such as timing of the release of an effective vaccine, November’s US Presidential election, and the escalating tension between the US and China ‒ continue to cloud the markets. Such uncertainties do mean one thing ‒ market volatility will remain elevated. Both historical realized and one-month at-the-money (ATM) implied EURUSD FX volatilities are hovering near 8%, which is almost double that of pre-COVID-19 levels. This presents opportunities in the FX and FX vols markets for us. Interestingly, over the last five years, the one-month ATM implied volatility has been leading the realized volatility observed in the market. Current market positioning is also very heavily tilted to short USD, as reflected by the open interests of asset managers’ long EUR/USD positions hitting record highs.

While many of us are experienced in trading the FX spot market, we are less familiar with FX options (FXO) as a trading and hedging instrument. FXO opens a new dimension for us as traders and risk managers. Its advantages include:

• Limited downside.  By definition, we have the right and not the obligation to exercise the option as buyers of options. Therefore, we do limit our losses if we are wrong.
• Preserves our position in a whippy market. More often than not, trading positions get stopped out in highly volatile markets. This is perhaps one of the strongest advantages of holding an option as it allows us to keep our positions as we navigate the storms.
• Enhanced leverage. Unlike a spot transaction, option strategies do not require us to put up the entire notional amount. This is especially true for out-of-the money options.
• Focuses our trading strategy across key events. Options trading allows us to pick the maturities of the options, which in turn enables us to focus our trading on key market events.
• Yield enhancement strategy. In a situation where we are already long the underlying, we can sell call options, thereby creating a covered-call strategy to increase the overall alpha of our portfolio.
• Hedging. While the most effective hedge of a position is to simply square it, this is not a feasible alternative for a lot of portfolio managers, due to the transactional costs and related complexities for large portfolios. Therefore, buying options serves as a good insurance for hedging purposes under such scenarios.

With the advantages of adding options in our arsenal of trading instruments explained, let’s explore the differences between the two major platforms where FXO are traded. OTC FXO is where clients trade FXO with prices made by banks. This is also where the bulk of the global interbank market lies.  However, FXO is also listed in exchanges like CME Group (CME), where it has various advantages over the OTC market such as:

• Round-the-clock liquidity. With the commitment of market makers, CME can ensure liquidity in the trading of FXO on its GLOBEX platform. These FXO contracts will deliver into FX futures, which are also traded 24 hours with good liquidity.
• Level playing field. Unlike interbank trading portals with embedded last look features for the price maker, an exchange traded central order book is more transparent, as it allows all participants to work their orders, and ensures that all orders are treated equally with anonymity.
• No default risks. As with other exchange traded products, CME is your counterparty for the FXO contracts. Hence, in a post-global financial crisis era, this credit mitigation is a huge benefit (we have enough things keeping us awake as it is!)
• Regulated market place. Being an exchange, there are very clear trading rules that are religiously enforced which include not least, the FX Global Code of Conduct.
• Margins offset and central clearing. There is a likelihood that you have existing positions on other exchange traded products. Therefore, there will be offsetting margin benefits among them. For financial institutions, having the FXO cleared by CME also ensures that we reduce the amount of capital that is required for outstanding risk positions with the implementation of the Uncleared Margin Rules (UMR).  A recent Greenwich Associates report, not only illustrates this capital efficiency effect, it also compared the savings of executing CME FX options versus buy-side OTC in terms of liquidity costs.

As a regulated all-to-all FX options venue, CME provides a diversified range of product and services in the FXO space. Together with a broad spectrum of strikes available, FXO contracts maturities are listed to cater for both short-term and longer-term trading strategies.

For short-term trading, CME has weekly FXO contracts that mature on Mondays, Wednesdays, and Fridays. This allows traders to utilize these lower premium options to focus on specific market events e.g. Friday maturities for non-farm payroll (NFP) announcements. These shorter-term contracts also serve as good instruments for those who engage in the gamma trading in their FXO portfolio. 

Longer-term traders and traders who would like to trade the vols per se can look at serial (monthly) and quarterly maturity FXO contracts. Provided that existing screen pricing is inadequate, there is also a Request for Quote (RFQ) functionality. Point to note, though some dealing portals might have actual larger trading volumes going through, it might not be available to all participants in the market, resulting again in an uneven playing field.

One very useful tool to help us plan and manage our options strategies is the free online QuikStrike Calculator and Strategy Simulator. These analysis tools allow us to structure our FX options strategies using current market prices and simulate the impact to our portfolio as the Greeks change.