FX Options
FX Option Prices
How are FX Options priced?
Spot Forex prices are quoted in tiny increments called pips, or "percentage in point". A pip refers to the fourth decimal point out, or 1/100th of 1%. For example, a strike price on a EUR/USD currency option could be listed as 1.3027.
For Japanese Yen, pips refer to the second decimal point. This is the only exception among the major currencies.
Options have several factors that collectively determine their value:
Intrinsic Value: how much the option would be worth if it were to be exercised right now. The position of the current price in relation to the strike price can be described in one of three ways:
- "In the money" - For calls, this means the strike price is lower than the current market price. For puts, the strike price is higher than the current market price. If an option is in the money, it is more advantageous to exercise the option than buy the underlying security directly.
- "Out of the money" – For calls, this means the strike price is higher than the current market price. For puts, the strike price is lower than the current market price. In both situations, it is cheaper for an investor to buy the underlying security in the market directly.
- "At the money" – This means the strike price is at the current market price.
Time Value: This represents the amount of time the option has left before expiration, as well as the uncertainty of the price over time. Generally, the more time remaining before expiration, the higher premium you pay for the option.
Interest rate differential: Any change in interest rates affects the relationship between the strike price of the option and the current market rate. This effect is often factored into the premium as a function of time value.
Volatility: Higher volatility increases the likelihood of the market price hitting the strike price within a limited time period. Volatility is factored into the time value. Typically, more volatile currencies have higher options premiums.
When the above four factors are calculated, FX option quotes are displayed with a purchase and sale price (the bid and ask) identical to any exchange traded equity or index option.