By its definition, an Option gives the buyer the right (not an obligation) to exercise the contract on the expiry date. This brings out a popular reason for the forex market players to choose trading in this instrument, that’s “liquidity”. High liquidity with full choice to not exercise the contract that’s not feasible, is what makes currency options a likely choice in Forex trading.
Valuation of FX options is very crucial as it determines the market psychology & trade flow. Value of the options is largely influenced by factors like market volatility, underlying asset’s price, expiration time, interest rates, margin amount and cost of carry.
Currency Option values are calculated using constructive models of valuation. When the buyer wishes to exercise his right of the contract, he needs to understand if his decision will make profit or loss. Hence, forming graphical analysis is one way to arrive at the value of the option. If Mr. John has one call option at a strike price of $5000 for one stock of company XYZ, he would certainly not exercise the option where the spot price of this stock is less than $5000.
This option would only make profit when the stock price surges higher. This scenario is termed as “option in-the-money” In this example; an increase in the stock price will lead to an increase in the value of the option. Similarly, if the spot price of the stock is less than or reduces than the strike price of the option, the option is termed as “out-of-the-money”. The intrinsic value of the option will be zero, when the spot price is equal to or lower than the strike price. This example concludes that the call option cannot have a value lesser than its intrinsic value, where
Intrinsic Value = Spot Price – Strike Price
Similarly, for a put currency option, the value of the option decreases with a rise in the spot price of the market.
Valuation of currency options is done through few recognized valuation models. The binomial model and Black-Scholes model are widely used valuation models. These models are mostly used to value European options, where the option can be exercised only at the expiry of the contract. While both the valuation models are popular, the difference between them comes from the approach towards the change in the stock price. The binomial model approaches a “binomial method” towards the percent change in the stock price and the Black-Scholes model embraces a “normal log method”.
Binomial model basically follows a numerical method to value options. Stock price at the beginning and end of the valuation period is the base tool in arriving at the value of the option. The Black-Scholes formula is based on many assumptions those can affect the value of the option. This method is supposedly more comprehensive way to generate relative prices. This method is based on natural algorithm and an assumption that the stock price deviates frequently. Since this formula is known to produce values in a reasonable range, it is regarded as a time tested and dependable method.