How Options affect FX Spot

1. How to complicate things

Delta, Gamma and volatility (“vols”) are concepts that are familiar to all options traders…but not to spot traders. However, the sheer volume of options transactions in the FX markets makes it worthwhile to understand options, at least a little bit. We will be keeping things as simple as possible – evidently because we are not trading options and only need to concentrate on those aspects that can help paint a more comprehensive picture of the market.
To be precise, we will be talking about Volatility, Market Pin Risk and the most common option structures in the FX market. But first, we need to introduce some option basics.
2. What is an Option?
An Option, in it’s most basic form, is a “right” to buy or sell something. A Call Option on the Euro is the right (but not the obligation) to buy Euros, at a specific date (expiry date), at a specific price (strike price). A Put option is the right (but not the obligation) to sell Euros at a specific date (expiry date) at a specific price (strike price).
Options can of course be bought or sold. The option buyer pays a price (premium) to receive the option because he is buying the right to buy (call) or sell (put) the underlying (Euros in our example) and thus has to pay for this right. The option seller (writer) gets paid the premium and is thus exposed to the risk of exercise (the option buyer may decide to exercize his right to buy or sell the underlying, which is taken or given to the option seller).
Charting the payoff of a Plain Vanilla Call and Put, with the various Deltas per each price.
Source: FX Traders Magazine
 
3. Introducing Delta
In the above diagram, we have illustrated the payoff (profit/loss) for a Plain Vanilla Call and Put. Looking at how the price of the option reacts to movements in spot…more

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