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Chapter 6

All About Trading In Currency Options And Futures

Currency futures were launched in India in the year 2008 and have gradually picked up volumes in the Indian markets over the years. Currency futures in India are cash settled and provide trading in rupee pairs as well as well cross currency pairs.

A. KEY PARTICIPANTS IN THE CURRENCY FUTURES MARKET

There are different types of players active in the currency futures market and each has a role to play in price discovery and in creating breadth and depth in the currency futures market. Here are some key players in the currency futures market.

Short term traders: They take positions in various currencies and the view could range from as short as an intraday position to a few days. These traders basically try to play a trend in the market, either positive or negative. Short term traders are agnostic to the direction of the market trend. Short term traders don’t have any underlying exposure to the currency.

Long term positional traders: They are an extension of the trader concept but they take a longer term view on currency. Such currency view can extend even up to 12-18 months. Normally, they don’t get liquid futures in the far month so they are open to rolling over the currency futures for a longer period of time.

Spread traders: Unlike the directional traders, the spread traders don’t take any directional view on any currency. They are indifferent to whether the particular currency strengthens or weakens. They largely focus on the spread between the current month and next month and directly trade on the spread window. They normalize premiums/discounts in the market.

Options and futures scalpers: They are an extension of traders but these scalpers operate on very thin margins but large volumes. Scalpers focus on very minor mispricing in the currency futures and the options market and capitalize on the same. Normally, such scalp trades are hard to execute manually and are done through algorithmic programs only.

Hedgers: They are one of the most important players in the currency futures market and they normally have an underlying exposure to the particular currency. The hedger could be an importer, an exporter, a foreign currency borrower etc. The intention is not to profit from trading in currencies but just to hedge the price risk of the currency exposures.

Central Banks: In India, the RBI also intervenes in the currency market through the currency futures market. When the RBI needs to sterilize dollar inflows or prevent the rupee from weakening, they normally buy or sell dollars in the spot market. But this has an impact on the total forex reserves of the RBI and also on domestic liquidity. Hence the RBI combines spot market intervention with intervention through futures.

B. MANAGING RISK AND RETURNS THROUGH CURRENCY FUTURES

Returns are what you earn on a currency and risk is the volatility you accept to earn that return. The task of any trader in the currency market is to optimize returns i.e. maximize returns for a given level of risk or to minimize risk for a given level of return. We understand the concept of managing risk, but how do currency futures help to manage returns?

How currency futures help to manage returns?

Currency futures actually help to manage returns in two ways.

Firstly, you can manage your returns better with currency futures due to the power of leverage that currency futures offer. The typical margin on a USDINR contract is around 3% (including SPAN and ELM). That means for a single lot of $1000, your margin is just $30 or Rs.2,100/-. This allows you to take larger positions in currency futures even with lower margins.

Secondly, currency futures allow you to lock in returns. Let us say you have a payable of £10,000 for your son’s education after 6 months and are holding Pounds at a spot rate of Rs.83/£. If the Pound strengthens to Rs.89/£, you can sell 10 lots of GBPINR futures and lock in the profit of Rs.60,000. If the pound weakens further you can always cover your short position and retain your spot Pounds. Alternatively, if the Pound strengthens, there is a loss on futures but you don’t have to worry as you have spot Pounds with you. Thus you are able to manage returns better with currency futures.

How currency futures help to manage risk?

The most important risk that currency futures help you to manage is the risk of adverse movement in any of the hard currencies like the dollar, Pound, Euro and Yen. If you are an importer, you can hedge your risk by buying USDINR futures to protect yourself from weakening of the rupee. Alternatively, if you are an exporter, you can sell USDINR futures to protect yourself against strengthening of the rupee. Of course, the risk of unlimited losses on futures can also be resolved by participating through currency options.

C. REGULATORY FRAMEWORK WITH RESPECT TO CURRENCY FUTURES

The overall regulation of the Currency futures and options market is shared by the Reserve Bank of India (RBI) and the Securities & Exchange Board of India (SEBI). The Working Group on Currency Futures was set up in 2008 to study the international experience and suggest a suitable framework to introduce currency futures in India in line with the current legal and regulatory framework. Following the recommendations of the Working Committee, RBI and SEBI jointly constituted a Standing Technical Committee to evolve norms and oversee implementation of Exchange Traded Currency Derivatives.

Accordingly, the RBI issued the Currency Futures (Reserve Bank) Directions, 2008 which came into force effective August 6, 2008. While the macro implications pertaining to impact on the rupee, currency volatility and reference pricing comes under the ambit of the RBI, other exchange related aspects like membership of the currency futures market, account opening, trade management and its separation from other client trading comes under SEBI regulations. Also, SEBI regulates the risk, surveillance and margining pertaining to currency futures as well as the clearing and settlement of currency futures contracts.

Banks authorized by the Reserve Bank of India under Section 10 of the Foreign Exchange Management Act (FEMA) 1999 as “A.D. Category-I Bank” are permitted to become trading and clearing members of the currency futures market of the recognized stock exchanges; on their own account and on behalf of their clients. This is subject to fulfilling certain minimum prudential requirements pertaining to net worth, non-performing assets etc.

NSE was the first exchange to receive in-principle approval from SEBI for setting up currency derivative segment. Currency futures trading commenced in 2008 with the launch of currency futures trading in US Dollar-India Rupee (USD-INR).

D. WHEN TO GO LONG ON (BUY) CURRENCY FUTURES?

What do we understand by going long on currency futures? Going long implies that you buy the currency futures. Currency futures are always traded in pairs. In India, the following pairs are permitted viz. USDINR, EURINR, GBPINR and JPYINR. We will not get into cross currency futures at this point of time. To understand when to go long on futures, let us take a live example of the price sheet from the NSE and look at two different circumstances viz. when should a trader go long and when should a hedger go long?

The above screenshot shows USDINR futures for the March 2019 contract expiring on 27th March. In this contract, the USD is the base currency and the rupee is the quotation currency. The USD (base currency) is expressed in terms of the quotation currency with the closing price at Rs.69/$. There are two occasions on which to go long on the USDINR futures above.

  • A trader would go long on currency futures when they are expecting the base currency to strengthen or the quotation currency to weaken. In the above instance, if the trader expects the dollar (base currency) to strengthen from 69/$ to 72/$, then the trader would buy (go long) on the USDINR futures. Let us assume that trader bought 20 lots of USDINR futures with a notional value of $20,000 (20 lots x $1000 per lot). When the dollar strengthens to 72/$, the trader can book profit of Rs.60,000 {$20,000 x (72 – 69)}. Of course, there will be transaction costs and statutory costs but the logic is that trader will buy the future when they expect the base currency to strengthen.
  • Typically, an importer or a foreign currency borrower who has a payable in dollars at a future date will go long on USDINR futures as in the above case. Why is that so? An importer or a foreign currency borrower who has a dollar payable will be keen to protect from a stronger dollar as it mean that they will have to arrange more rupees for the same amount of dollars committed. This can be hedged by buying USDINR futures. The losses on the spot currency will be compensated by the profits on the USDINR futures and the dollar payable is protected in terms of rupees.

E. WHEN TO GO SHORT ON (SELL) CURRENCY FUTURES?

Let us first try and understand what is meant by going short on currency futures? Going short implies that you sell the currency futures. Currency futures are always traded in pairs. In India, the following pairs are permitted viz. USDINR, EURINR, GBPINR and JPYINR. Instead of a USDINR illustration, let us now take a GBPINR illustration to understand selling of currency futures. Based on the screen shot of the NSE below let us look at two different circumstances viz. when should a trader go short and when should a hedger sell GBPINR?

The above screenshot shows GBPINR futures for the March 2019 contract expiring on 27th March. In this contract, the GBP is the base currency and the rupee is the quotation currency. The GBP (base currency) is expressed in terms of the quotation currency with the closing price at Rs.90.81/£. There are two occasions on which to go short on the GBPINR futures above.

  • A trader would go short (sell) on currency futures when they are expecting the base currency to weaken or the quotation currency to strengthen. In the above instance, if the trader expects the Pound (base currency) to weaken from 90.81/£ to 88.00/£, then the trader would sell (go short) on the GBPINR futures. Let us assume that trader sold 10 lots of GBPINR futures with a notional value of £10,000 (10 lots x £1000 per lot). When the Pound weakens to 88/£, the trader can book profit of Rs.28,100 {$10,000 x (90.81 – 88.00)}. Of course, there will be transaction costs and statutory costs but the logic is that trader will sell the future when they expect the base currency to weaken.
  • Typically, an exporter who has receivables in Pounds at a future date will go short on GBPINR futures as in the above case. Why is that so? An exporter who has a Pound receivable will be keen to protect from a weaker pound as it mean that they will get fewer rupees for the same amount of pounds committed. This can be hedged by selling GBPINR futures. The losses on the spot currency will be compensated by the profits on the GBPINR futures sold and the pound receivable is protected in terms of rupees.

F. WHEN TO BUY CURRENCY CALL OPTIONS

Currency call options are exactly like other call options (a right to buy without an obligation to buy). You normally buy a call option when you are bullish on the price movement. In case of currency pair, you buy call options when you expect the base currency to strengthen or the quotation currency to weaken on a relative basis. So you will buy a USDINR call option when you expect the USD to strengthen versus the Indian rupee. Let us take a NSE screen shot as under:

The above screenshot captures the details of the USDINR April 26th contract with strike price of Rs.69.50 when the spot price of the dollar is Rs.69/$. The cost of the call option is Rs.0.4225, which is the sunk cost and is the maximum loss that the buyer of the option will have to pay. When to buy call options on the USDINR?

When you expect the dollar to strengthen vis-à-vis the rupee, the trader can either buy USDINR futures or buy a call option. The advantage in the call option is that it gives a limited risk and a limited loss strategy and the worst case loss can be defined in advance. On the upside; once the cost of premium is covered (i.e. above 69.9225) the profits for the call holder can be virtually unlimited.

G. WHEN TO SELL CURRENCY CALL OPTIONS

Before we get into currency call options selling, we need to understand that selling currency calls is not a bearish view. On the other hand, they are more of a neutral view with downside bias. The expectation is that the USD is unlike to go much above the sum of strike price and the option premium. You normally sell a call option when you are neutral and don’t expect the price to go much higher. In case of currency pair, you sell call options when you don’t expect the base currency to strengthen too much or the quotation currency to weaken too much. Let us take a NSE screen shot as under:

The above screenshot captures the details of the USDINR April 26th contract with strike price of Rs.69.50 when the spot price of the dollar is Rs.69/$. The premium of the call option is Rs.0.4225, which is the maximum income / profit of the seller of the call option. However, losses can be unlimited on the upside once the sum of (strike plus premium) is covered. When to sell call options on the USDINR?

When you don’t expect the dollar to strengthen too much vis-à-vis the rupee, the trader can sell a call option with a view to retaining the premium. The call option sold gives a limited upside to the extent of the premium received but unlimited losses if the dollar really strengthens aggressively. On the upside; once the strike price and the premium is covered (i.e. above 69.9225) the losses to the call holder can be virtually unlimited.

H. WHEN TO BUY CURRENCY PUT OPTIONS

Currency put options are exactly like other put options (a right to sell without an obligation to sell). You normally buy a put option when you are bearish on the price movement. In case of currency pair, you buy put options when you expect the base currency to weaken or the quotation currency to strengthen on a relative basis. So you will buy a USDINR put option when you expect the USD to weaken versus the Indian rupee. Let us take a NSE screen shot as under:

The above screenshot captures the details of the USDINR April 26th put contract with strike price of Rs.68.50 when the spot price of the dollar is Rs.69/$. The cost of the put option is Rs.0.2200, which is the sunk cost and is the maximum loss that the buyer of the put option will have to incur. When to buy put options on the USDINR?

When you expect the dollar to weaken vis-à-vis the rupee, the trader can either sell USDINR futures or buy a put option. The advantage in the put option is that it gives a limited risk and a limited loss strategy and the worst case loss can be defined in advance. On the upside; once the cost of premium is covered (i.e. below 68.2800) the profits for the put holder can be virtually unlimited.

I. WHEN TO SELL CURRENCY PUT OPTIONS

Before we get into currency put options, we need to understand that currency put selling is not a bullish view. On the other hand, they are more of a neutral view with upside bias. The expectation is that the USD is unlikely to go much below the (strike price minus option premium). You normally sell a put option when you are neutral and don’t expect the price to go much lower. In case of currency pairs, you sell put options when you don’t expect the base currency to weaken too much or the quotation currency to strengthen too much. Let us take a NSE screen shot as under:

The above screenshot captures the details of the USDINR April 26th put option contract with strike price of Rs.68.50 when the spot price of the dollar is Rs.69/$. The cost of the put option is Rs.0.2200, which is the maximum income / profit of the seller of the put option. However, losses can be unlimited on the downside once the price of (strike - premium) is covered. When to sell put options on the USDINR?

When you don’t expect the dollar to weaken to much vis-à-vis the rupee, the trader can sell a put option. The put option sold gives a limited upside to the extent of the premium received but unlimited losses if the dollar really weakens aggressively. On the downside, once the strike price minus the premium are covered (i.e. below 68.2800), the losses to the put option seller can be virtually unlimited.

J. PAYOFFS OF A CURRENCY CALL OPTION

For the above instance, let us look at how the payoffs would look at for the buyer of the call option. Remember, that the buyer of the call has the premium as the maximum loss. The pay off chart lays out the profit or loss at various price points. Check the table below:

Stock Price Call Strike Premium ATM/OTM P/L on Price Net P/L
65.00 70.00 0.3125 OTM - -0.3125
66.00 70.00 0.3125 OTM - -0.3125
67.00 70.00 0.3125 OTM - -0.3125
68.00 70.00 0.3125 OTM - -0.3125
69.00 70.00 0.3125 OTM - -0.3125
70.00 70.00 0.3125 ATM - -0.3125
71.00 70.00 0.3125 ITM 1.00 0.6875
72.00 70.00 0.3125 ITM 2.00 1.6875
73.00 70.00 0.3125 ITM 3.00 2.6875
74.00 70.00 0.3125 ITM 4.00 3.6875
75.00 70.00 0.3125 ITM 5.00 4.6875

As can be seen from the above chart, the maximum loss is limited to Rs.0.3125, which is the premium paid on the call option for the right. The call option is out of the money (OTM) at all price levels below 70 and hence will be left to expire worthless. On the upside, the profits can be unlimited once the premium cost of Rs.0.3125 is covered in the trade. Let us now also look at how the payoff chart will look like for the trader who has sold the above call option.

Stock Price Call Strike Premium ATM/OTM P/L on Price Net P/L
65.00 70.00 0.3125 OTM - 0.3125
66.00 70.00 0.3125 OTM - 0.3125
67.00 70.00 0.3125 OTM - 0.3125
68.00 70.00 0.3125 OTM - 0.3125
69.00 70.00 0.3125 OTM - 0.3125
70.00 70.00 0.3125 ATM - 0.3125
71.00 70.00 0.3125 ITM -1.00 -0.6875
72.00 70.00 0.3125 ITM -2.00 -1.6875
73.00 70.00 0.3125 ITM -3.00 -2.6875
74.00 70.00 0.3125 ITM -4.00 -3.6875
75.00 70.00 0.3125 ITM -5.00 -4.6875

In the case of the seller of the call options, the payoffs are the reverse of the buyer of the call option. The seller of the USDINR call option will always prefer the call option to expire either OTM or ATM. That is when they get the entire premium as their income. Above Rs.70, their losses can be unlimited and the losses are only reduced by the amount of premium received by the seller of the option. At no point is the total profit of the seller of the option greater than the total premium on the call option.

K. PAYOFFS OF A CURRENCY PUT OPTION

For the above instance, let us look at how the payoffs would look at for the buyer of the put option. Remember, that the buyer of the put has the premium as the maximum loss. The pay off chart lays out the profit or loss at various price points. Check the table below:

Stock Price Put Strike Premium ATM/OTM P/L on Price Net P/L
65.00 69.75 0.3350 ITM 4.75 4.4150
66.00 69.75 0.3350 ITM 3.75 3.4150
67.00 69.75 0.3350 ITM 2.75 2.4150
68.00 69.75 0.3350 ITM 1.75 1.4150
69.00 69.75 0.3350 ITM 0.75 0.4150
70.00 69.75 0.3350 OTM - -0.3350
71.00 69.75 0.3350 OTM - -0.3350
72.00 69.75 0.3350 OTM - -0.3350
73.00 69.75 0.3350 OTM - -0.3350
74.00 69.75 0.3350 OTM - -0.3350
75.00 69.75 0.3350 OTM - -0.3350

As can be seen from the above chart, the maximum loss is limited to Rs.0.3350, which is the premium paid on the put option for the right. The put option is out of the money (OTM) at all price levels above 69.75 and hence will be left to expire worthless. On the downside, the profits can be unlimited once the premium cost of Rs.0.3350 is covered in the trade. Let us now also look at how the payoff chart will look like for the trader who has sold the above put option.

Stock Price Put Strike Premium ATM/OTM P/L on Price Net P/L
65.00 69.75 0.3350 ITM -4.75 -4.4150
66.00 69.75 0.3350 ITM -3.75 -3.4150
67.00 69.75 0.3350 ITM -2.75 -2.4150
68.00 69.75 0.3350 ITM -1.75 -1.4150
69.00 69.75 0.3350 ITM -0.75 -0.4150
70.00 69.75 0.3350 OTM - 0.3350
71.00 69.75 0.3350 OTM - 0.3350
72.00 69.75 0.3350 OTM - 0.3350
73.00 69.75 0.3350 OTM - 0.3350
74.00 69.75 0.3350 OTM - 0.3350
75.00 69.75 0.3350 OTM - 0.3350

In the case of the seller of the put options, the payoffs are the reverse of the buyer of the put option. The seller of the USDINR call option will always prefer the put option to expire either OTM or ATM. That is when they get the entire premium as their income. Below Rs.69.75, their losses can be unlimited and the losses are only reduced by the amount of premium received by the seller of the option. At no point is the total profit of the seller of the put option greater than the total premium on the put option.

L. BREAKEVEN-POINT FOR CURRENCY CALL OPTION AND PUT OPTION

Breakeven point is the point at which there is no profit and loss to the buyer and the seller of the option. Let us look at the call option first.

Call option:

X buys the USDINR call option April contract at a strike price of Rs.70 at a premium of Rs.0.3125. Breakeven point is the profit of no profit and no loss.

For the buyer of the call option, the breakeven will be Rs.70.3125 (70.0000 + 0.3125). Up to the strike price, his loss is the premium paid of 0.3125. Above 70 and up to 70.3125 he keeps reducing his loss of premium paid. At Rs.70.3125, he makes no profit and no loss. Above this level, his profits can be unlimited depending on how high the USDINR goes.

For the seller of the call option also, the breakeven will be Rs.70.3125 (70.0000 + 0.3125). Up to the strike price, his profit is the premium received of 0.3125. Above 70 and up to 70.3125 he keeps reducing his profits earned. At Rs.70.3125, he makes no profit and no loss. Above this level, his losses can be unlimited depending on how high the USDINR goes.

Put option:

Y buys the USDINR Put option April contract at a strike price of Rs.69.50 at a premium of Rs.0.3350. Breakeven point is the profit of no profit and no loss.

For the buyer of the put option, the breakeven will be Rs.69.1650 (69.5000 - 0.3350). Up to the strike price, his loss is the premium paid of 0.3350. Below 69.50 and up to 69.1650 he keeps reducing his loss of premium paid. At Rs.69.1650, he makes no profit and no loss. Below this level, his profits can be unlimited depending on how low the USDINR goes.

For the seller of the put option also, the breakeven will be Rs.69.1650 (69.5000 - 0.3350). Up to the strike price, his profit is the premium received of 0.3350. Below 69.50 and up to 69.1650 he keeps reducing his profits earned. At Rs.69.1650, he makes no profit and no loss. Below this level, his losses can be unlimited depending on how low the USDINR goes.

INTRINSIC VALUE OF CURRENCY OPTION

A call option is the right to buy an asset without the obligation to buy that asset while a put option is the right to sell without the obligation to sell. You agree to buy or sell the asset at a price which is called the strike price. If the market price is above the strike price then the call option has a positive intrinsic value. If the market price is below the strike price then the put option has a positive intrinsic value. Look at the formula below:

Call Options

Intrinsic value = Underlying Stock's Current Price - Call Strike Price

Put Options

Intrinsic value = Put strike price = Underlying stock price

Time Value in both the cases

Call Premium - Intrinsic Value

Let us look at a live scenario of an in-the-money call option

Source: NSE

The above is a case of a call option of strike Rs.69.50 when the spot price is Rs.69.65 for the USDINR April contract. Since the market price is greater than the strike price it will be in the money (ITM) option.

Intrinsic value = 69.65 – 69.50 = 0.15

Total Premium = Rs.0.4575

Time Value = Total Premium - Intrinsic Value

= 0.4575 – 0.15000 = 0.3075

The understanding of intrinsic value and time value are closely related and need to be interpreted in relation to each other.

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