Have you ever noticed those strange occurrances when a trade seems to continue pressing against an invisible barrier and just can’t break through? Most likely your trade is caught in the headwinds of a strong option barrier or a cluster of optionality.
AUDUSD 1H Chart illustrating the strong resistance encountered just a few pips ahead of 0.7700
The sheer volume of options transactions in the FX markets makes it worthwhile to understand some basic principles of options. we are not trading options and being market practitioners, only need to concentrate on those aspects that can help paint a more comprehensive picture of the market.
An Option 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)
The illustration above shows the price of a call options (grey curved line) together with the tangents for different spot prices (the slope of the tangent lines is called the delta of the option) and the payoff at expiry (blue line). Notice that the price of the option always remains above the tangent line.
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).
The illustration above shows the price of a put option (grey line), along with the tangent lines for different spot prices (the slope of the tangent lines is the delta of the option) and the payoff at expiry (blue line). Notice that the price of the option is always above the tangent line.
Options can 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 exercise his right to buy or sell the underlying, which is taken or given to the option seller).
The Importance of Delta
In the illustrations above, 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, we can see that
- call options appreciate when spot rises
- put options depreciate when spot rises.
This is the foundation of the convention that delta is positive for calls and negative for puts. However, the change in the option price is not the same for the same spot move across the curve. This is visually illustrated by drawing tangent lines to the price curve of the option. The slope of the tangent tells us how much the price of the option moves with respect to the underlying, per each movement in spot.
Delta = the Change in Option Value / Change in the Underlying
The Option Delta has various practical interpretations, which make it easier for market participants to exchange information about it.
- Delta = Volatility of the Option, which is also dependant on the Volatility of the Underlying.
- Delta = Hedge Ratio. Here is a simple example. If FXR stock is worth 100 USD/share, and we own 100 Options of FXR shares at 20% Delta, then
+ 1USD in FXR shares = + 20 cents in the value of a Call option * 100 = USD 20
+ 1USD in FXR shares = – 20 cents in the value of a Put option * 100 = USD -20
So the Delta tells us how much we need to hedge (i.e. Sell in the underlying if we own calls or buy in the underlying if we own put) so that Option position P/L = Spot P/L.
- Delta = Probability of expiring In The Money (ITM). Option prices can be seen as a representation of the market’s expectation of the future distribution of spot prices. The Delta of an option can be thought of roughly as the probability of the option finishing in the money (which would benefit the option holder, or buyer). For example, given a one-month FXR call option with a strike price of 104 and a delta of 50, the probability of FXR finishing above 104 one month from now would be approximately 50%.
Delta Hedging & “Sticky” Prices
One reason why plain vanilla options are influential within the FX market is the “delta hedging” that comes with them. The larger expiries, which are reported on tools such as the CME Most Active Strike page, represent “Pin Risk”:
large vanilla clusters can exert attraction if price is close to the strike at maturity. This is important because a large expiry will require more delta-hedging, and other players will be aware of these dynamics and may decide to “play the range” around the expiry.
CME’s Most Active Strike page on AUDUSD: it’s clear that the 7650-7750 area is the most active optionality area.
Pin Risk, like in the above example, is the risk that the option expires at or close to the strike rate. Primarily this is a risk for traders who are short the options (so the option writers, which are usually investment banks) because the trader doesn’t know whether he will be exercised – assigned the underlying – or not. The option is At The Money (ATM) and Delta is 50% so there is a big question mark on the trader’s head. And since these are big expiries, the risk is very tangible, and the trader must do something about it! What they do is Delta Hedge around the strike.
AudUsd illustrating who wins vs who loses depending on where spot is at expiry.
So what happens is that there is usually buying below the strike and selling above the strike. This makes price “sticky”. Various banks will be net short puts or net short calls, and various market players will be net long calls or net long puts…and this just makes it easy for the spot price to gravitate around the expiry. If a couple of conditions are met:
- there cannot be strong market drivers (or sentiment) during the expiry day. Option expiries have maximum effect when there are no evident flows going through the pipes on the day of expiry.
- price must be “close”, i.e. 30/50 pips away, in order to gravitate towards the strike rate.
Unless these 2 conditions are met, traders can ignore the plain vanilla option expiries and their Pin Risk.
But this still doesn’t explain the strong selling seen ahead of the 0.7700 level.
The most common Exotic Option in FX: Barrier Options
We hear a lot of talk about “Barrier Options” in FX, because they tend to be the most common option issued within the institutional space. Barrier options are part of the Exotic Digital Option Family:
- Exotic means the payoff can be more complex than simple “plain vanilla” options
- Digital means the option can only have 2 outcomes and thus is much easier to understand (and to attribute a nominal value to) than a normal “plain vanilla” option.
The illustration above shows the payoff of a One-Touch barrier options entered with spot price below the barrier. The green payoff line is what the trader will receive if the barrier is touched during the life of the option. The blue payoff line is what the trader will receive if the barrier is not touched during the life of the option. The one-touch option pays out if the price of the underlying touches the barrier before expiry. The Option buyer wants the barrier to be touched. The option seller (usually investment banks) will fight hard to defend the barrier.
The illustration above shows the payoff of a No-Touch barrier option, entered with spot price below the barrier. The green payoff line is what the trader will receive if the barrier is touched during the life of the option. The blue payoff line is what the trader will receive if the barrier is not touched during the life of the option. The no-touch option pays out if the price of the underlying does not touch the barrier before expiry. Option sellers (usually investment banks) will want spot price to touch the barrier before expiry and will push for this to happen.
The illustration above shows the payoff of a Double-No-Touch option. The green line is the payoff if one of the barriers is touched during the life of the option. The blue payoff line is what the trader earns if none of the barriers are touched during the life of the option. The double-no-touch option pays out if the price of the underlying stays within a range, not touching either the lower or the upper barrier of this range before expiry.
These digital options function like bets by paying a predetermined amount if a certain condition is met. The payoff is thus the full amount or nothing, which gives rise to the term “digital”.
How to Identify Barrier Options
So how do we know there’s a barrier at some level or another? Unfortunately Exotic Options are negotiated Over The Counter (OTC) and are not reported on the CME website or on professional platforms like Reuters EIKON (which reports DTCC data).
Fortunately there is a rule of thumb to follow: if the market has not touched a round number (like 0.7700 in our example) for over 1 month, then there is probably a barrier at that level.
AudUsd 1H chart illustrating the Barrier defence at 0.7700
And now for the important take-away: how and why does the barrier affect the spot rate?
A bank owning a barrier at 0.7700 in AudUsd will receive a large payout if the barrier is not touched. So it will act to defend the barrier. How will it do this?
- the bank will look to sell spot just ahead of the barrier, and will look to buy it back a little lower – so it can use the profits made to re-load on the next barrier attack
- the bank will sell options with higher strikes higher strikes (above 0.7700) and, with the premium received, sell spot in order to defend the barrier
- the bank will sell volatility (via delta-hedged option structures which we will not cover here) and use the proceedings to sell spot.
Option trading can and does influence the spot market. This can happen around big vanilla expiries (Pin Risk through delta hedging) or option barriers (via barrier protection). However, focusing on these details or including these details into your trading plan might overcomplicate things.
So my personal suggestion would be to add these observations into your personal “market culture” and be aware of potential barrier defence or option clusters but do not let this block you from taking a trade that ticks all the boxes of your tested trading plan.
About the Author
Justin Paolini is a Forex trader and member of the team at www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.