JPM Introduction To FX Options

Global FX Strategy
5 November 2010
Introduction to Foreign Exchange Options
FX Derivatives
Arindam SandilyaAC
(1-212) 834-2304
arindam.x.sandilya@jpmorgan.com
Matthias Bouquet
(44-20) 7777-5276
matthias.bouquet@jpmorgan.com
www.morganmarkets.com/GlobalFXStrategy JPMorgan Chase Bank NA

The certifying analyst is indicated by an AC. See page 75 for analyst certification and important legal and regulatory disclosures.
FX Vol Trading 101.ppt
Agenda
Basics of options 3
Option Pricing Theory 13

OP TI O N S
Volatility 26
Option markets as a source of intelligence for spot markets 34

E XC H AN G E
Measuring risks in option portfolios 43

F O R E I G N
Directional trading using options 55
Trading volatility as an asset class 66

T O
I N T R O D U C TI O N
I N T R O D U C TI O N T O F O R E I G N E XC H AN G E OP TI O N S
OPTION TERMINOLOGY
USER INPUTS
INTRODUCTION TO FX OPTIONS
CALL OPTION PAYOFF AT EXPIRATION
Yields payout in numeraire currency pips per unit of asset

Call option payoff = Max (S-K, 0) currency notional e.g. JPY per USD in the case of
USD/JPY. To convert JPY payout into USD, divide by the
where S = price of underlying, K = exercise price going spot rate at expiry i.e. USD payout = max (S-K,0)/S
The linear profile shown below therefore only holds when

payout is plotted in numeraire currency pips. The payout
S Max (S-K, 0) Max (S-K,0)/S profile is NOT linear when plotted in terms of the asset
currency
60 0 0
OP TI O N S
An option that delivers a linear payout profile in the asset

65 0 0 currency is called a QUADRATIC option.
70 0 0
75 0 0
E XC H AN G E
80 0 0
85 0 0
90 0 0
95 0 0
F O R E I G N
100 0 0
105 5 0.0476
110 10 0.0909
115 15 0.1304
T O
K
120 20 0.1667
125 25 0.2000
130 30 0.2308
135 35 0.2857
Out of the money In the money
At the money
4
PUT OPTION PAYOFF AT EXPIRATION
Yields payout in numeraire currency pips per unit of asset

Put option payoff = Max (K-S, 0) currency notional e.g. JPY per USD in the case of
USD/JPY. To convert JPY payout into USD, divide by the
where S = price of underlying, K = exercise price going spot rate at expiry i.e. USD payout = max (K-S,0)/S
The linear profile shown below therefore only holds when

payout is plotted in numeraire currency pips. The payout
S Max (K-S, 0) Max (K-S,0)/S profile is NOT linear when plotted in terms of the asset
currency
60 40 0.6667
OP TI O N S
An option that delivers a linear payout profile in the asset

65 35 0.5385 currency is called a QUADRATIC option.
70 30 0.4286
75 25 0.3333
E XC H AN G E
80 20 0.2500
85 15 0.1765
90 10 0.1111
95 5 0.0526
F O R E I G N
100 0 0
105 0 0
110 0 0
115 0 0
T O
K
120 0 0
125 0 0
130 0 0
135 0 0
In the money Out of the money
At the money
5
OPTION PREMIUM QUOTATION
Conventions Conversion from one convention to another

Assume that USD/JPY is the currency pair of interest.
AC = Asset Currency
USD is referred to as the base or asset currency, JPY is NC = Numeraire Currency
referred to as the terms or numeraire currency
Option premium can be expressed in %AC = %NC x Strike

Percent of asset currency notional (% USD)
Spot
OP TI O N S
Percent of numeraire currency notional (% JPY)

Units of numeraire currency per unit notional of %NC = %AC x Spot
the asset currency (JPY per USD)
Strike
Units of asset currency per unit notional of the
E XC H AN G E
numeraire currency (USD per JPY)

NC per AC = % NC X Strike
Example AC per NC = %AC

The two-way premium of a 6M 90 strike USD put / JPY Strike
F O R E I G N
call (spot 90.25) in $10MM may be expressed as:

1. 4.07 4.17% $ In the earlier example, the USD/JPY option is
2. 4.08 4.19% offered at 4.19% JPY, spot is 90.00 and the strike
3. 3.6775 3.7710 per $ of the option is 90.25; hence the price of the
T O
4. $ 0.00045250 0.00046333 per option in JPY per unit USD notional is

Buy Option in $ 10MM : Premium = $ 417,000 JPY per USD = 4.19% x 90 = 3.7710
Buy Option in 900MM : Premium = 37,710,000 or 377 JPY pips per USD
Buy Option in $ 10MM : Premium = 37,710,000 X 1 X So X 1 X SoK
S0 K S0
Buy Option in 900MM : Premium = $ 417,000 NC pips %AC % NC AC pips NC pips
6
INTRINSIC VALUE AND TIME VALUE
Prior to expiration, call options trade at prices higher than their in-the-moneyness, also referred to as their
intrinsic value.
- Intrinsic value of an in-the-money call = S K
- Intrinsic value of an in-the-money put = K S
- Intrinsic value of out of the money options = 0

OP TI O N S
The difference between the option value and the intrinsic value is the time value of the option. Time value
represents the additional value of an option due to the opportunity for the intrinsic value of the option to
increase. Mathematically, Option Value = Intrinsic value + Time value
E XC H AN G E
F O R E I G N
?
T O
TIME VALUE
INTRINSIC VALUE
K
7
PAYOUT vs. P/L PROFILES
P/L of an option differs from its Long Call Short Call

payout by the amount of the Payoff / P/L Payoff / P/L
option premium.
Because option premium is non-
p
zero, there is a breakeven spot
rate only beyond which an p
option trade makes or loses p

OP TI O N S
money at expiry.
p
Breakeven spot rates: Spot rate Spot rate at

Call options: Strike + Premium at maturity maturity
Put options : Strike - Premium Strike
E XC H AN G E
Strike
Example Long Put Short Put

Q. What is the breakeven spot rate Payoff / P/L Payoff / P/L
for a 1.50 strike EUR call/USD put
that costs 1.0% EUR? Spot =1.45
F O R E I G N
Ans.
Convert 1.0% EUR to USD per EUR P
1) % USD = % EUR * Spot / Strike P

T O
= 1 * 1.45/1.50 =0.97%
P
2) USD per EUR = % USD * Strike
P
= 0.97%*1.50 = 0.0145
Breakeven spot rate Spot rate at
maturity
Spot rate
at maturity
= Strike + Premium
Strike Strike
= 1.50 + 0.0145 = 1.5145
8
PUT CALL PARITY
Buy a call + sell a put = Synthetic long forward

Assume 6M USD/JPY forward is at 100
Consider the following position
Long a 6M 100 strike USD Call / JPY Put
Short a 6M 100 strike USD Put / JPY Call
Payout Table
OP TI O N S
E XC H AN G E
F O R E I G N
Put-Call Parity Relationship for any strike K Implications
- rfT - rdT
One can replicate any of (put, call, forward)
CP=Se - Ke
using the other two instruments
T O
(rd rf)T
or, given that F = S e ATMF calls and puts have the same price
- rdT (plug F = K in the second put call parity

CP= e (F - K) expression)
9
BASIC OPTION STRATEGIES
Call Spread Put Spread Risk-Reversal Straddle

Long 90 Call + Short 100 Call Long 100 Put + Short 90 Put Long 100 Call + Short 90 Put Long 90 Call + Long 90 Put
OP TI O N S
E XC H AN G E
Strangle Butterfly Condor Calendar Spread

Long 90 Put + Long 100 Call Long 90 Call + 2* Short 100 Call + Long 85 Call + Short 90 Call + Short 3M 100 Call + Long 1Y 100
Long 110 Call Short 95 Call + Long 100 Call Call
F O R E I G N
T O
10
BASIC OPTION STRATEGIES CASE : CALL/ PUT SPREADS FOR TRADING CARRY
In general, carry in a trade refers to the P/L that can Trading carry using USD/BRL forwards vs. options
Short USD/BRL forwards at 1.7603
potentially accrue to the investor if market conditions
were to remain unchanged over the trade horizon.
In FX, carry trading refers to a strategy of buying high
yielding currencies and selling low yielding currencies,
via forward transactions. Since FX forwards are a
function only of spot and the two interest rates in
OP TI O N S
question, a carry trader stands to pocket the difference

between the two rates as long as the exchange rate at Long USD/BRL 1.7603 / 1.75 put spread
the expiry of the forward has not moved so far against
the trade since inception as to wipe away all the interest
E XC H AN G E
rate gains.
Consider USD/BRL as an example:
Spot (S) = 1.75 | r
BRL,1M = 7.38% | rUSD,1M = 0.30%
Forward (F) = 1.75* [1+ 7.38% * (1/12)]/[1+0.30%*(1/12)]
F O R E I G N
= 1.7603
The carry trade is to sell 1M USD/BRL forwards at 1.7603 Historical performance of forwards vs. options
All options and forwards are 1M in tenor, and rolled into fresh instruments
at the expiry of the previous one. No transaction costs. Unit notional/leg on
The alternative to trading carry through forwards is to use the put spread, forward notional sized so that 2-sigma monthly loss is equal
to the put spread premium
options. The optionalized version of the carry trade in this
T O
instance is to buy 1M ATMF (i.e. strike = forward = 1.7603)

USD puts/BRL calls and sell 1M ATMS (i.e. strike = spot =
1.75) USD puts/BRL calls

Optionalized carry is motivated by the rationale that in the
event of an adverse spot move, the downside from the put
spread is floored at the option premium (p), unlike in the case
of forwards where theoretical downside is unlimited
11
Agenda
Basics of options 3

OP TI O N S
Volatility 26

E XC H AN G E

F O R E I G N

T O
1
OPTION PRICING BASICS
Consider a one period call option with the following characteristics:
Spot price = 100
Exercise price = 100

OP TI O N S
Volatility = 20% per period
Periods to expiration = 1
E XC H AN G E
Short-term interest rate = 1% per period

F O R E I G N
T O
13
PRICING THE CALL OPTION
Step 1: Determine the distribution of spot price at expiration
Today Expiration
S = 120
S = 100 Strike = 100

OP TI O N S
S = 80
E XC H AN G E
Step 2: Value the option at each possible spot price at expiration

The 100 call option gives the holder the right to buy the underlying at a price of 100. The call will be
worthless if the underlying price is less than 100 at expiration. On the other hand, if the underlying price is
greater than 100, the value of the call will be the difference between the underlying price and 100.
F O R E I G N
Today Expiration
S = 120
c = 20
T O
Strike = 100
S = 100
S = 80
c= 0
14
PRICING THE CALL OPTION (CONTD)
Step 3: Calculate the expected value of the option

Suppose you think that there is a 50% chance that the price will rise and a 50% chance the price will fall.
Your expected value of the option is simply:
1 1
x [call value with S = 120] + 2 x [call value with S = 80]
2
OP TI O N S
1 1
= x [20] + x [0]
2 2
E XC H AN G E
= 10
Step 4: Calculate the present value of the option

F O R E I G N
Most options require the buyer to pay an up-front premium. On the other hand, the payoff to the option is
not received until some time in the future. The price of the option should therefore reflect the present
value of the expected payoffs. With a one period interest rate of 1%, the present value is:
T O
10
9.90 =
(1 + 0.01)
15
PRICING THE CALL OPTION (CONTD)
What if a different market participant has a different reading of movement probabilities?

Your friend thinks that there is a 70% chance that the price will rise and a 30% chance the price will fall.
His/her expected value of the option is then:
7 3
x [call value with S = 120] + 10 x [call value with S = 80]
10
OP TI O N S
7 3
= x [20] + x [0]
10 10
E XC H AN G E
= 14
Present value of the option is then

F O R E I G N
14
13.86 =
(1 + 0.01)
T O
DOES THE PRICE OF THE OPTION DEPEND ON SUBJECTIVE READING OF MARKET PROBABILITIES?
16
VOLATILITY IS AN IMPORTANT DETERMINANT OF OPTION PRICING
Suppose we increase the price variability of the underlying.
Today Expiration
S = 140
OP TI O N S
S = 100 Strike = 100

E XC H AN G E
S = 60
1 1 1
Your option price = X x 40 + x 0 = 19.8
F O R E I G N
1.01 2 2
1 7 3
Your friends option price = X x 40 + x 0 = 27.7
T O
1.01 10 10
AT LEAST YOU AGREE ON THE FACT THAT RISING PRICE VARIABILITY LEADS TO HIGHER OPTION PRICES
17
ARBITRAGE-FREE PRICING OF A CALL OPTION
As a trader, assume you are short a call. How would you structure a trade such that you are perfectly
hedged in both the up and down scenarios?
Say, you need to buy x shares of stock to hedge yourself
Long Stock Long Call Short Call + long x stock

OP TI O N S
Value Value Portfolio payoff
$120 $20 -20 + 120 * x

E XC H AN G E
$100
$80 $0 0 + 80 * x
F O R E I G N
To be perfectly hedged,
T O
-20 + 120 * x = 0 + 80 * x, or x = 0.50. i.e. buy 1/2 a share of stock to hedge yourself
In both up and down scenarios, portfolio payoff = -20 + 0.5*120 = 0.5*80 = $40
The short call + 0.5*long stock portfolio is thus riskless, assured of a $40 value irrespective of the
state of the world
18
ARBITRAGE-FREE PRICING OF A CALL OPTION (CONTD)
A riskless portfolio should earn the riskless rate of interest
Thus, the PV of future cash flows of the riskless portfolio has to equal the price at which the portfolio is
trading today
OP TI O N S
Value of portfolio today = 0.5 * 100 c, where c is the call price
Guaranteed portfolio payoff in both scenarios

E XC H AN G E
$40 / (1+0.01) = 0.5 * 100 - c
Thus, c = $10.39
NO PROBABILITIES WERE NECESSARY ONLY THE NO ARBITRAGE PRINCIPLE IS NEEDED

F O R E I G N
T O
19
RISK-NEUTRAL PROBABILITIES
Although no probabilities are required for pricing options, risk-neutral probabilities may be estimated
A risk-neutral world is one where investors care only about expected returns, not the risk associated
with earning it
In a risk-neutral world all assets will earn the risk-free rate

expected return from the underlying stock is the risk free rate
OP TI O N S
expected return from the call option is also the risk free rate
Let
E XC H AN G E
p = probability of an up move
q = 1-p = probability of a down move
{ (120) p + (80)q } / 100 = 1 + 0.01

p = 0.525; q = 0.475
F O R E I G N
Since the call also earns the riskless rate of return, its value is now the discounted value of the expected
payoff
call premium = (0.525 * $20 + 0.475 * 0) / 1.01 = $10.39
T O
Risk-neutral probabilities are a mathematical trick that provides an intuitive way to price options. Our
intuitive valuation of options as the discounted value of expected payoffs is true when using so-
called risk-neutral probabilities
20
BLACK SCHOLES OPTION PRICING
The Black Scholes (BS) model of option pricing used Risk-neutral option pricing in a two-state world
a no-arbitrage replicating portfolio argument similar Payout
to the one that we used before, but in a continuous ST - K

spot price setting instead of a discrete one.
BS models assume that spot follows a geometric

brownian motion. This implies that the risk-neutral
OP TI O N S
ST
S1 K S2
probability distribution of spot at maturity, ST, is
lognormal. This means that log (ST) is normally
max(S1 - K, 0) = 0 max(S2 - K, 0) = S2 - K
distributed.
E XC H AN G E
p1
e-r(T-t) [0*p1+ (S2-K)*p2] p2
If you know the risk-neutral probability distribution

of the terminal spot level ST, then you can use the Risk-neutral option pricing in a continuous world
principle of risk-neutral option valuation that the (ST)
F O R E I G N
option price is simply equal to the discounted

expected payoff from the option under the risk-
neutral probability measure to arrive at an
analytical expression for the price of an option.
T O
Garman and Kohlhagen extended the BS model to

cope with the presence of two interest rates (one for

each currency). The Garman and Kohlhagen (GK)

c = e-rT [pi*max(Si -K,0)] = e r (T t ) (ST K ) (ST )dST
model is the standard BS model for FX options. K
21
BLACK SCHOLES OPTION PRICING (CONTD..)
Notations Assumptions of the Black Scholes Model

S0 = Spot rate at inception (Asset / Numeraire)
Spot price follows a geometric Brownian
K = Strike motion i.e. terminal spot values are
T = Time to maturity in years lognormally distributed
rf = Asset (foreign) ccy interest rate The spot process has constant volatility.
rd = Numeraire (domestic) ccy interest rate There are no transaction costs to impede
OP TI O N S
S = Volatility (in %, annualized) the creation of continuously hedged

portfolios of options and spot
Garman Kohlhagen FX Option Pricing Formulae
All securities are perfectly divisible (i.e. it
Price of a call option is possible to buy any fraction of a share).
E XC H AN G E
There are no restrictions on short selling.

There is no arbitrage opportunity
Price of a put option
F O R E I G N
Note
An options price is NOT just its discounted

where
average payout, unless one operates using
risk-neutral probabilities
T O
Subjective assessments of the expected

rate of return from spot do not enter into

the option pricing formula
N(z) is the standard normal cumulative distribution
function given by
22
CAN YOU PRICE THIS OPTION.
..assuming you can price any call option?

OP TI O N S
E XC H AN G E
F O R E I G N
K1 K2 K3 K4
T O
23
FACTORS DETERMINING OPTION VALUE
There are six factors that affect the value of an option. The chart below is a handy way of referencing them.
Factor European Call European Put
+ -
OP TI O N S
Underlying Price
Strike - +
E XC H AN G E
Volatility + +
F O R E I G N
Risk-Free Domestic Rate + -

Can you think of a situation
when increasing the time
Time to Maturity + + to maturity lowers the
T O
value of a put option?

Foreign Interest Rate

(equivalent to dividends
for equity options)
- +
24
Agenda
Basics of options 3

OP TI O N S
Volatility 26

E XC H AN G E

F O R E I G N

T O
2
MEASURING VOLATILITY
Volatility is a measure of the variability of prices or Volatility is the dispersion of the spot return distribution
yields.
Historical Volatility measures how variable prices or

yields have been. It is usually measured as the
annualized standard deviation of daily percentage
changes over some historical period. 68.3%
95.4%
OP TI O N S
Implied Volatility is a forecast of how variable the

underlying price or yield is expected to be over the
remaining life of the option. This forecast is
calculated from an option premium as the level of 1 standard deviation 2 standard deviations
E XC H AN G E
volatility that gives a theoretical option price equal

to its market price.
Given the volatility of returns, one can assign probabilities
to various spot scenarios assuming a normal distribution
Most option pricing models measure volatility as the
20%
(annualized) standard deviation of the percent
change in the underlying spot price.
F O R E I G N
15%
If percentage changes in the spot price are normally 10%

distributed, 68% of them will be within 1 standard
5%
deviation of the mean.
T O
100 0%
For example, with spot at 100, a 5% annualized

volatility means that there is a 68% chance that -5%
prices will be between 95 and 105 a year from now. -10%
Similarly, there is a 95% chance that prices will be
between 90 and 110 . -15%
-20%
26
SAMPLE HISTORICAL VOLATILITY CALCULATION
Step 1: Collect closing prices Step 2: Calculate daily returns (percent changes)
P1 = 99.48
R = P 2
P1
=
99 . 73 99 . 48
=
0 . 25
= 0 . 0025 (0.25%)
P2 = 99.73
2
P 1
99 . 48 99 . 48
P3 = 99.00
R = P 3
P2
=
99 . 00 99 . 73
=
0 . 73
= 0 . 0073 (-0.73%)
P4 = 98.00
3
P 2
99 . 73 99 . 73
OP TI O N S
R = P 4
P3
=
98 . 00 99 . 00
=
1 .0
= 0 . 010 (-1.0%)
4
P 3
99 . 00 99 . 0
Step 3: Calculate a standard deviation of daily returns Step 4:Convert daily volatility to annual volatility
E XC H AN G E
Two assumptions are commonly used when converting a

Daily volatility =
(R 2 R ) + (R
2
3R ) + (R
2
4 R )
2
daily volatility to an annual volatility:
n -1 Todays underlying price change is independent of
yesterdays price change.
where R is the mean of the daily returns and n is the
The volatility of the underlying price is keyed to
F O R E I G N
number of daily returns.

trading days rather than calendar days. We use 252
In this example, business days in a trading year. (Bloomberg uses
0 .0025 0 .0073 0 .010
260.)
R= = 0 .00497
3 Taken together, these two assumptions imply that the
variance of annual percentage price changes is 252
T O
(0.0025 - (- 0.00497 ))2 + (0.0073 - (- 0.00497 ))2

times the variance of daily price changes. Since
+ (0.0010 - (- 0.00497 ))2
Daily volatilit y = volatility is simply the standard deviation (square root

2 of the variance) of daily percentage price changes:
= 0 .00663
Annualized volatility = 252x Daily volatility
= 15.87 x Daily volatility
In the above example,
Annualized volatility = 15.87 x 0.00663 = 10.52%
27
MEASURING HISTORICAL VOLATILITY
Mathematical formulae Additivity of variance and annualization factors

S i N 2 S
1 ln i
Non mean adjusted or RMS volatility = * ln * 252
N i = 1 S i-1
Let us re-visit the RMS volatility formula and denote the daily return
by ri. S i-1
M returns N-M returns
N 2
1 Si
Mean adjusted volatility = * ln
N -1 i = 1 S i-1
* 252 ,
So S1 S2 SN-1 SN
S3 SM
where S i = Spot on day i
N + 1 = Total no. of spot observations r1 r2 r3 rN
OP TI O N S
N days
N
1 S i
= * ln
N i = 1 S i-1
For the entire sequence of N returns observed above, the expression for
sample RMS variance is shown below. Note that this is the square of the RMS
Notes
volatility
The first thing to realize about realized volatility is that it is NOT a known
quantity, just a MEASURE. The true volatility of any underlying can, and often [
RMS variance, N2 = r12 + r22 + r32 + ....rN2 / N ( A ) ]
E XC H AN G E
is different from the measured volatility. The method of measuring realized

volatility depends upon the purpose that one needs it for. Now let us chop the whole return sequence into two parts a chunk of M returns
and another chunk of N-M returns as shown above. Similar to the variance
Non-mean adjusted or RMS volatility is the measure of volatility that is truly
expression above, we can write the variance of the two return chunks as:
[ ]
consistent with the P/L of a delta-hedged option (refer to the expression for net
P/L of a delta-hedged option earlier), and is more relevant for an option trader RMS variance, M2 = r12 + r22 + r32 + ....rM2 / M (B)
Mean-adjusted volatility differs from RMS volatility in that it de-trends spot RMS variance, N2-M = [
rM2 +1 + rM2 + 2 + rM2 + 3 ]
+ ....rN2 /( N M ) (C )
F O R E I G N
returns, and captures the noise around the mean. It is more relevant for
market observers seeking to simply quantify the uncertainty or noise around spot Equations (A), (B) and (C) yields:
trends.
M M2 + ( N M ) N2- M
Clearly, RMS and mean-adjusted measures of realized volatility will be equal N2 =
when m = 0 i.e. spot observations display no trend, but can differ significantly N
T O
over small windows of time when spot is trending sharply

120 103 Annualization of volatility/variance
102 The core assumption of annualization is that any observed sample of returns will repeat
115
its pattern over the remainder of the year (approx. 252 trading days)
101
110 The variance of any sample of daily returns can be annualized by multiplying by 252
100
105 The volatility of any sample of daily returns can be annualized by multiplying by 252
RMS vol = 22.8% 99 RMS vol = 16.5%
Mean-adj. vol = 16.9% Mean-adj. vol = 16.9% The variance of any sample of weekly returns can be annualized by multiplying by 52
100 98
The volatility of any sample of weekly returns can be annualized by multiplying by 52
0 5 10 15 20 0 5 10 15 20
28
HISTORICAL VOLATILITY IN FX
Realized FX volatility has seen high and low and in fact has been reasonably well correlated
regimes, like every other asset class. with equity volatility
OP TI O N S
E XC H AN G E
Realized vol in some currency pairs like USD/JPY and not so much in some others like EUR/USD
are strongly correlated to spot moves.
F O R E I G N
T O
29
IMPLIED VOLATILITY
Implied volatility in FX is a 3-D surface, being quoted Implied volatility in FX is a surface

Vol (%)
for options of different tenors and deltas (not fixed The term structure of vols
strikes, as in equities). can steepen or flatten
The vol surface
This presents a problem when an option buyer (or
can move up or
down in parallel
seller) asks the price of an option of a given strike:
The skew can
1. One can only read the implied vol of an option from steepen or flatten
the vol surface if the delta of the option is known. Th
OP TI O N S
the e o
2. But given spot, strike and interest rates, the elta lt of vo ption
s d l te r
p ti o n a re s u d rm olls
calculation of the delta of the option itself needs a o s an
The ges a f time d the str up
uc or
n
volatility input (remember Black Scholes formula for cha sage o pot an tur d
s e ow
pas es in n
v e
delta) i.e. vol cannot be known unless delta is known, mo urfac
s
vol 10
E XC H AN G E
and delta cannot be calculated unless vol is known. In +2

5
Te
other words, delta and vol have to be simultaneously no
r( AT
M
M) lta
computed. -25 De
-10
The convention for quoting implied vols for the whole
surface is to quote ATM vols, risk-reversals and
F O R E I G N
butterflies for 10D and 25D strikes (called pillars) Implied vols are quoted in terms of ATMs, risk-
Risk-reversal (RR) = Call vol Put vol reversals and butterflies
Butterfly (BF) = (Call vol + Put vol)/2 - ATM

To retrieve vols for the individual calls and puts, one
T O
must simultaneously solve for the call and put vols:

Call vol = ATM + BF + (RR/2)
Put vol = ATM + BF - (RR/2)
Example: 3M ATM = 20.8, 3M 25D RR = 6.8, 3M 25D BF = 1.1

3M 25D Call vol = (20.8) + 1.1 + (6.8/2) = 25.3
3M 25D Put vol = (20.8) + 1.1 (6.8/2) = 18.5
30
IMPLIED VOLATILITY CONTD
Term structure of volatility Volatility skews

Usually refers to the term structure of Represent the variation of implied vol with
ATM implied vols. strike for options of a given tenor
The normal term structure of vols is Strikes are quoted in terms of delta rather
upward sloping. than absolute spot values (sticky delta
rule)
High realized volatility, or anticipation
thereof, pushes all vols higher, with Some currencies exhibit a high degree of
front-end vols moving more than back- skew (e.g. AUD/USD, USD/JPY) while
end vols. This leads to inversion of the others have relatively lower skew (e.g.
OP TI O N S
vol curve. EUR/USD)
Vol curves tend to be mean-reverting Skews reflect the option markets

in nature, much more so than expectation of a change in ATM implied
implied vols themselves.
E XC H AN G E
vols for a given move in spot

This renders curves amenable to Hence skews are well correlated to the
mean-reversion based trading correlation between spot and vol moves.
strategies like fading curves that look Think of spot-vol corr. as the realized
historically steep or flat / inverted skew
Pure curve trades can be expressed Skews can consistently defy spot-vol
by buying and selling two options in
F O R E I G N
correlations in the presence of structural

vega-neutral amounts (similar to factors, as in the case of JPY and JPY-
duration-neutral yield curve trades) crosses.
Moves in vol curves are led by those In addition to spot-vol correlation, skews
in front-end vols. are often valued by comparing them to the
T O
level of the ATM vol

Since front-end vols are primarily
gamma plays, a view on gamma is Also, the popularity of carry trades in FX
essential to formulating a curve means that currency pairs with the highest
view. carry attract the most flows, and are
there-fore susceptible to the sharpest
If back-end vols are considered to be
unwinds. As a result, skews tend to be bid
the sum of front-end vols AND the vol
higher for carry currency puts in those
curve, a view on each of these
currency pairs.
quantities can be aggregated to form
a back-end vol view
31
VXY: AN INDEX OF FX IMPLIED VOLATILITY

Prior to the launch of VXY, there was no industry Composition of VXY EM
benchmark for tracking aggregate volatility in currencies
analogous the CBOE Volatility Index (VIX) used in
equity markets.
VXY is an index of 3M ATM vols across liquid G7 USD-
pairs, with index weights based on the BIS Triennial
Central Bank Survey of turnover in foreign exchange and
derivative markets.
The VXY indices serve three main functions:
OP TI O N S
Establishes a benchmark for risk premium in FX

Informs currency trading styles, since performance
of carry strategies are inversely correlated to vol
Facilitates volatility trading through delta-one
E XC H AN G E
products such as forwards and swaps on the index

Bloomberg tickers: JPMVXYG7 Index, JPMVXYEM Index
Composition of VXY G7
VXY G7 and EM history
F O R E I G N
T O
32
Agenda
Basics of options 3

OP TI O N S
Volatility 26

E XC H AN G E

F O R E I G N

T O
3
OPTION VALUATION RECAP
The price of an option is the discounted value of expected

future cash flows similar to the price of any other
Payout
financial asset.
The computation of expected cash flows is dependent on ST - K
the distribution of spot price at expiry. In a world where

spot at expiry (ST) can take on only two discrete values S1
OP TI O N S
and S2, with risk-neutral probabilities p1 and p2, the option

ST
K
price can be simply written as e-r(T-t) [p1*max(S1-K,0) + S1 S2
p2*max(S2-K,0)].
max(S1 - K, 0) = 0 max(S2 - K, 0) = S2 - K
E XC H AN G E
In a continuous world, spot at expiry can take on an infinite

p1
e-r(T-t) [0*p1+ (S2-K)*p2] p2
number of values, and hence we need a probability
distribution of spot in order to arrive at the option price1. (ST)
Given any probability distribution of terminal spot p(ST),

F O R E I G N
the price of a call option can be written mathematically as

c (t , K , T ) = e r (T t ) E * [max( ST K ,0 )]

= e r (T t ) (ST K ) (ST )dS T
T O
K
- r : continuously compounded discount rate
- E* : expectation taken under the risk-neutral probability measure

- p(ST): risk-neutral probability density function of the terminal spot price
ST
c= e-rT

[pi*max(Si -K,0)] = e r (T t ) (ST K ) (ST )dST
K
1 In a classical Black-Scholes setting, this distribution is assumed to be lognormal.
34
EXTRACTING OPTION IMPLIED DISTRIBUTIONS FROM OPTION PRICES
The risk-neutral probability density function is the second
derivative of the market call price with respect to the strike

price1:
2 c (t , K , T )
= e r (T t ) ( K ) K -K K K +K
K 2
Computing derivatives of call option prices
Implementing this approach requires, in principle, options c (t, K , T ) c(t,K + K,T) - c(t, K , T )
=
OP TI O N S
on a continuous (or at least closely spaced) series of strike K K

c(t,K + K,T) - c(t, K , T ) c(t,K,T) - c(t, K K , T )
prices on the asset price axis. 2 c(t, K , T ) K K
=
K 2 K
In practice, not enough option contracts with different c(t,K + K,T) - 2c(t, K , T ) + - c(t, K K , T )
=
E XC H AN G E
strikes on a given asset with a given maturity trade K 2
simultaneously. Hence we interpolate across the volatility

smile to arrive at prices for a set of options with closely
= 0 + 1 + 22 + 33 + 44
F O R E I G N
spaced strikes.
This is more involved than it first appears, because the
volatility smile in FX is quoted for implied volatilities Volatility

Delta
T O
against deltas, not strikes. But delta itself is a function of

volatility, as dictated by Black-Scholes math. This creates a

circularity, and hence for any given strike, both delta and
volatility need to be simultaneously solved for.
1 This fact was first noted by Breeden and Litzenberger (1978)
35
HAIL BLOOMBERG !!!!!
36
MOMENTS OF OPTION IMPLIED DISTRIBUTIONS

The first moment of the implied distribution is the The second moment of the implied distribution is
forward a function* of the ATM variance
There is no incremental information that is to be gleaned For M2 therefore, just the ATM vol is enough of a proxy,
from the option market as regards M1 the rest of the vol surface is immaterial
OP TI O N S
E XC H AN G E
* ATM2 = ln (M2/M12)
F O R E I G N
The skewness* of the implied distribution is highly The kurtosis* of the implied distribution is highly
correlated to risk-reversals (call vol put vol) correlated to butterflies
T O
* Kurtosis = M4/M22
* Skewness = M3/M23/2
37
TRADING SPOT FX USING IMPLIED MOMENTS : 2002 - PRESENT

Trading spot in G10 using rule-based signals from the option market Returns from trading USD/CHF and USD/JPY using momentum in 3M ATM
vols: Returns based on spot and vol momentum are positively correlated
USD/CHF USD/JPY
OP TI O N S
E XC H AN G E
Returns from trading AUD/USD and NZD/USD using momentum in 3M ATM

vols: Returns based on spot and vol momentum are negatively correlated
F O R E I G N
NZD/USD AUD/USD
The study tests the efficacy of spot trading by applying a 20-day momentum rule to all
variables. The variables are spot itself, forwards, ATM vols, risk reversals and butterflies.
25D Risk Reversal (RR) = 25D Call Vol 25D Put Vol; 25D Butterfly (FLY) = 25D Call Vol + 25D
Put Vol 2* ATM Vol
T O
Trading rule: If variableT > = 20D moving average of the variable, buy spot, else sell spot
When the signal variable is spot itself, the trading rule becomes a simple technical / spot
momentum algorithm. In order to provide incremental tradeable intelligence, trading
results based on option market data need to outperform those from spot momentum rules.
The spot momentum rule therefore becomes the control / anchor for this study
The upper number in % denotes annualized % return, the lower number denotes information
ratio:
annualized % return
IR
Returns shown in the table are purely FX returns i.e. they have no carry component
No transaction costs assumed
38
TRADING SPOT FX USING IMPLIED MOMENTS : 2002 PRESENT (CONTD)

Trading spot in G10 using rule-based signals from the option market Returns from trading AUD/USD and NZD/USD using momentum in
1Y - 3M ATM vol spread
AUD/USD
OP TI O N S
E XC H AN G E
NZD/USD
F O R E I G N
Vol Term Structure Dynamics

T O
39
TRADING SPOT FX USING IMPLIED MOMENTS : 2007 PRESENT

Trading spot in G10 using rule-based signals from the option market
Takeaways
As signals for directional trading the vol surface really matters for high Risk-reversals widely considered to be an indicator of positioning / risk
skew currency pairs, not as much for those with low skews sentiment (and therefore in theory crucial to the performance of high
Momentum in ATM vol has historically been a decent indicator for spot beta currencies) are overrated as spot trading indicators
For AUD and NZD, the term structure of ATM vols is a much more
OP TI O N S
direction in USD/CHF and USD/JPY

significant predictive variable for spot direction than skews
E XC H AN G E
AUD, NZD and NOK spot

returns have been well
predicted by momentum
EUR, CHF and NOK spot returns have been
F O R E I G N
in the vol term structure

well predicted by momentum in the ATM
vols. In other words, EUR and NOK have
become much more pro-cyclical over this
period, with spot returns exhibiting
negative beta to vol momentum a la AUD
and NZD
T O
JPY has continued to be

well predicted by skew and
butterfly moves
40
OPTION IMPLIED INFORMATION CAN BE USEFUL AT TIMES
3
OP TI O N S
E XC H AN G E
F O R E I G N
4
T O
41
Agenda
Basics of options 3

OP TI O N S
Volatility 26

E XC H AN G E

F O R E I G N

T O
4
DELTA
Option price sensitivity
Delta is the change in the price of an option for a 1 unit move in the underlying. A delta of 0.5 means that a
one cent increase in the underlying price will cause a one-half of a cent increase in the option price. Hence,
the option price moves only half as much as the underlying price.
Hedge ratio (spot equivalence)

OP TI O N S
Since delta is a measure of how sensitive an option's price is to changes in the underlying, it is useful as a hedge
ratio. An USD/JPY option with a delta of 0.5 means that the option price increases by roughly 1 USD pip for
every 2 pip increase in the USD/JPY spot rate. For small changes in the spot price therefore, the option
behaves like one-half of spot.
E XC H AN G E
Constructing a delta hedge for a long position in $100mn notional of ATM USD/JPY calls with a delta of 0.5
would require you to sell $50mn of USD/JPY spot. (The delta of spot is always 1.)
Moneyness
F O R E I G N
Delta can be interpreted as the probability that an option will end up in-the-money. An at-the-money option,
which has a delta of approximately 0.5, has roughly a 50/50 chance of ending up in-the-money. Out-of-the-
money options have deltas less than 0.5; in-the-money options have deltas greater than 0.5.
T O
Call option deltas range between 0 and 1. Put option deltas range between 0 and -1.
The delta of a long option position increases as the underlying price increases. (This is true for both calls and
puts.) This reflects one of the main benefits of being long options compared to holding a position in the
underlying. A long option position becomes longer the market (delta increases) when the market is rallying and
shorter the market (delta decreases) when the market sells off.
43
DELTA (CONTD)
Call Deltas 100 Call Option Premium (10% vol) Put Deltas 100 Put Option Premium (10% vol)
Price
Increase as the Price Increase as the
underlying underlying price 3.5
3.5 Delta=-0.85
price increases Delta=0.85 increases 3 1 month to expiration
3
Can be 0.76 Can be 2.5 -0.75

2.5 interpreted as
interpreted as 1 month to expiration 2
0.64 -0.63
the probability 2 -1 times the 1.5
probability that -0.49
that the 1.5
0.5 1 expiration -0.36
OP TI O N S
option will 1 expiration the option will

0.37 0.5 -0.24
finish in the 0.24 finish in the -0.15
0.5
money money 0
0
97 98 99 100 101 102 103
97 98 99 100 101 102 103
E XC H AN G E
As time passes, 100 Call Option Deltas (1 month)

100 Call Option Deltas (10% vol) As volatility falls,
The delta of Delta
Delta The delta of ITM
ITM options 1 week 1 5%vol
1 options
increases increases 0.8
F O R E I G N
0.8 OTM deltas decrease

The delta of OTM deltas decrease The delta of 10% vol
OTM options 0.6 as vol falls
0.6 as time passes OTM options
decreases 4 months
decreases 0.4
0.4 ITM deltas increase
ITM deltas increase 0.2 as vol falls
0.2
T O
as time passes
0
0
97 98 99 100 101 102 103
97 98 99 100 101 102 103
44
DELTA (CONTD)
Time to expiration
Deltas of in-the-money call options increase towards 1 as time passes.
Deltas of out-of the money call options decrease towards zero as time passes.
Deltas become more changeable for at-the-money options as time passes.

OP TI O N S
Volatility
An increase in volatility raises the delta of out-of-the-money call options, and lowers the delta of in-the-
E XC H AN G E
money call options. At higher volatility levels, out-of-the-money options have a greater chance of ending up
in-the-money; in-the-money options have a greater chance of ending up out-of-the-money.
A doubling of volatility has roughly the same effect on an option's delta (and its price) as a quadrupling of
time. For example, the 100 strike call option delta is 0.92 with 1 month to expiration, spot = 102, and
F O R E I G N
volatility = 5%. If volatility increases to 10%, the delta falls to 0.76, which is about the same delta that a 4-
month option would have with volatility at 5%.
T O
45
WHAT DOES AN OPTION TRADER DO WITH HIS DELTA?
1M Call option delta hedged to maturity

OP TI O N S
E XC H AN G E
F O R E I G N
T O
Because we delta-hedge the option to maturity, and the option expires

worthless, naked option P/L is exactly equal to initial option price
multiplied by option notional
Realized volatility calculated using spot moves turns out to be 14.5
(more on this on the next slide), which is greater than the implied
volatility of 10.6 at entry. No wonder then that buying gamma turns out
to be a profitable venture.
46
GAMMA
Definition
An option's gamma is defined as the change in delta for a one unit change in the underlying price. Note that the unit
change in the underlying price may be defined differently depending on the option pricing model being used. In the
table above, it is defined as the change in delta for a one point move in the underlying; in Morgan Futures option pricing
software, it is defined as the change in delta for a .01 move in the underlying futures price (and then is multiplied by 100
to make the number easier to read).
The gamma of a long option position (both calls and puts) is always positive. This means that delta increases as the
OP TI O N S
underlying price increases and that delta falls as the underlying price falls.
Moneyness
ATM options have the largest gamma. The further an option goes in-the-money or out-of-the-money, the smaller is
E XC H AN G E
gamma.
Time to expiration
The gamma of an ATM option increases as time passes.

F O R E I G N
The gamma of in-the-money and out-of the money options will converge to zero at expiration.
Volatility
T O
An increase in volatility will lower the gamma of ATM options and raise the gamma of deep ITM and OTM options.
A doubling of volatility has roughly the same effect on an option's gamma as a quadrupling of time. For example, the
gamma of the 100 strike call option is 0.42 with 1 week to expiration, futures = 100, and volatility = 5%. If volatility
increases to 10%, the gamma falls to 0.27, which is about the same gamma that a 1-month option would have with
volatility at 5%.
47
GAMMA
Gamma is the 100 Call Option Premium (10% vol) ATM options have 100 Call Option Gammas (1 week)
change in delta the largest
for one unit gamma. 10% vol
Price
move in the Gamma
3.5 0.3 0.27
underlying. Delta=0.98
3
0.25
2.5
0.92 0.2
2 1week to expiration
OP TI O N S
1.5 0.15
0.77
1 0.5 expiration 0.1
0.5 0.24 0.05 0.06 0.06
0.07
0 0
97 98 99 100 101 102 103
E XC H AN G E
97 98 99 100 101 102 103
As time passes, 100 Call Option Gammas (10% vol) As volatility falls, 100 Call Option Gammas (1 month)
The gamma of The gamma of
F O R E I G N

Gamma Gamma
an ATM option an ATM option
0.3 0.3
increases 1 week increases 5% vol
0.25 0.25
The gamma of The gamma of
deep ITM and 0.2 deep ITM and 0.2
OTM options OTM options
0.15 0.15
T O
decreases decreases
0.1 1 month 0.1 10% vol
0.05 0.05
0 0
97 98 99 100 101 102 103 97 98 99 100 101 102 103
48
THETA (TIME DECAY)
Definition
Theta is defined as the change in the price of an option for a 1-day decrease in the time remaining to
expiration.
OP TI O N S
Moneyness
ATM options have the greatest time value and the greatest rate of time decay (theta). The further an option
E XC H AN G E
goes in-the-money or out-of-the-money, the smaller is theta.
Time to expiration
F O R E I G N
Theta increases as time passes for at-the-money options.
Volatility
T O
The time value of an option increases as volatility increases and so too does theta.
49
THETA (CONTD)
ATM Call Option Premium (10% vol) ATM options have 100 Call Option Thetas (1 week)
Theta is the
change in the the largest time
10% vol
value of an Premium value and the Theta (cents/day)
option with one Days to Expiration 120 30 7 largest theta.
2.5 4.5
days passage of Daily change in Premium 0.009 0.019 0.049 -4.09
4
time. 2 3.5
1.5 3
2.5
OP TI O N S
1 2
-0.19 -1.37
1.5 -1.28
0.5 10 days 1
0.5
0
0
120 90 60 30 0
E XC H AN G E
97 98 99 100 101 102 103

days to expiration
As time passes, 100 Call Option Thetas (10% vol) As volatility falls, 100 Call Option Thetas (1 week)
The theta of an ATMTheta (cents/day) Time value declines
option increases Theta (cents/day)
F O R E I G N
4.5 Theta declines 4.5

The theta of deep 4 4
ITM and OTM options3.5 1 week 10 % vol
3.5
decreases
3 3
2.5 2.5
T O
2 2
1.5 1 month 1.5
1 1 5% vol
0.5 0.5
0 0
97 98 99 100 101 102 103 97 98 99 100 101 102 103
50
VEGA
Definition
Vega is the change in the value of an option for a 1 percentage point increase in implied volatility. The
vega of a long option position (both calls and puts) is always positive.
OP TI O N S
Moneyness
ATM options have the greatest vega. The further an option goes in-the-money or out-of-the-money, the
smaller is vega.
E XC H AN G E
Time to expiration
Time amplifies the effect of volatility changes. As a result, vega is greater for long-dated options than for
F O R E I G N
short dated options.
Volatility
T O
An increase in volatility increases vega for in-the-money and out-of-the money options.
A change in volatility has no effect on the vega of ATM options. This means that ATM option prices
increase linearly with changes in volatility.
51
VEGA (CONTD)
Vega is the change in 100 Call Option Premium (1 month) ATM options have 100 Call Option Vega (1 month)
the price of an option the largest vega. 10% vol
for a one percentage Premium
Vega
point increase in 1.6 0.12
implied volatility. 1.4 1% F=100 0.11
1.2 0.114 0.1
1
OP TI O N S
0.09
0.8
0.08
0.6 F=98 0.07
0.4
0.06
0.2
0 0.05
0.04
E XC H AN G E
6 8 10 12 14
97 98 99 100 101 102 103
volatility
As time passes, ATM Call Option Vega (10% vol) As volatility falls, 100 Call Option Vega (1 month)
vega decreases
F O R E I G N

Vega Vega decreases for Vega
0.25
ITM and OTM 0.12
0.226 options 10 % vol
0.1
0.2 Vega is unchanged
for ATM options 0.08
0.15
T O
0.114 0.06
5% vol
0.1
0.04
0.05
0.02
0 0
120 90 60 30 0 97 98 99 100 101 102 103
days to expiration
52
PUTTING THE GREEKS TOGETHER GREEKS OF OPTION PORTFOLIOS

Given the Greeks of an option, it is possible to A single long call option position has
decompose the one period change in price of an Positive DELTA Negative THETA
option into the impact of different variables: Positive GAMMA Positive VEGA
Delta P/L = Delta * Change in spot
A single long put option position has
Gamma P/L = (1/2) * Gamma * (Change in spot)2 Negative DELTA Negative THETA
Theta P/L = Theta * Time Elapsed Positive GAMMA Positive VEGA
Vega P/L = Vega * Change in Implied Vol
OP TI O N S
Net P/L = Delta P/L + Gamma P/L + Theta P/L +

For a portfolio of options, notional-weighted Greeks are
additive. Suppose, a portfolio is long two options, in
Vega P/L
notionals N1 and N2
Example Portfolio Delta = N1* Delta1 + N2*Delta2
E XC H AN G E
Q. You are long a 6M 90 strike USD call/JPY put. Spot is Portfolio Gamma = N1* Gamma1 + N2*Gamma2
90.25. The option greeks are as follows: delta = 48, Portfolio Theta = N1* Theta1 + N2*Theta2
gamma = 5, theta = -2 bp/day, vega = 30bp. What is Portfolio Vega = N1* Vega1 + N2*Vega2
the change in price of the option if spot USD/JPY

F O R E I G N
rallied 1% over the next day, assuming that volatility Can you construct option portfolios that are:
of the option declined 0.4 percentage points as a Delta-neutral but long gamma?
result? Positive delta but neutral-gamma?
A. Change in spot = 1% = 100 bp Positive gamma but negative vega?
T O
Delta P/L = 0.48 * 100 = 48 bp Hint: Remember, Greeks can vary for different options
Gamma P/L = (1/2) * (5) * (1)2 = 2.5 bp of the same tenor if their strikes are different, and for
Theta P/L = - 2 bp/day * 1 day = -2 bp options of the same strike if their tenors are different
Vega P/L = 30 * -0.4 = -12 bp If you were uncertain as to the direction in which spot
Net P/L = 36.5 bp would move, but guessed that spot moves would be large in
either direction, which of these three portfolios would you
favor?
53
Agenda
Basics of options 3

OP TI O N S
Volatility 26

E XC H AN G E

F O R E I G N

T O
5
DIRECTIONAL TRADING THROUGH OPTIONS I: ONE TOUCH REPORT

OP TI O N S
E XC H AN G E
F O R E I G N
T O
55
EFFICIENT DIRECTIONAL TRADES

Bullish USD-vehicles Bearish USD-vehicles
X-axis denotes the historical rich/cheap of the distance from spot to barrier of a 3M X-axis denotes the historical rich/cheap of the distance from spot to barrier of a 3M
20% price one-touch option, with barriers struck in the direction of dollar strength. Y- 20% price one-touch option, with barriers struck in the direction of dollar weakness.
axis plots the current spot-barrier distance of the same option in # of std. deviations, Y-axis plots the current spot-barrier distance of the same option in # of std.
with 1 std. deviation being the 3M realized vol. No transaction costs. deviations, with 1 std. deviation being the 3M realized vol. No transaction costs.
OP TI O N S
E XC H AN G E
Bullish risk vehicles Bearish risk vehicles

X-axis denotes the historical rich/cheap of the distance from spot to barrier of a 3M
20% price one-touch option, with barriers struck in the pro-risk direction. Y-axis plots
the current spot-barrier distance of the same option in # of std. deviations, with 1 std.
deviation being the 3M realized vol. No transaction costs.
F O R E I G N
T O
56
DIRECTIONAL TRADING THROUGH OPTIONS II: RANGE BINARY REPORT

OP TI O N S
E XC H AN G E
F O R E I G N
T O
57
DIRECTIONAL TRADING THROUGH OPTIONS III: CONDITIONAL TRADES
BUY CCY CALLS/USD PUTS vs. SELL CCY CALLS/EUR PUTS

Long AUD Calls/USD Puts vs. Short AUD Calls/EUR Puts Long Gold Calls/USD Puts vs. Short Gold Calls/EUR Puts
1.50 1.30
1.45 AUDUSD/EURAUD 3M Implied Vol Spread 1.25 GLDUSD/GLDEUR 3M Implied Vol Spread
1.40 1.20
1.35 1.15
1.30 1.10
1.25
1.05
OP TI O N S
1.20
1.00
1.15
0.95
1.10
1.05 0.90
1.00 0.85
Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10
E XC H AN G E
The scatter chart plots rolling 3M returns for EUR/AUD against AUD/USD. The
isopremium line is constructed of (AUD/USD,EUR/AUD) strike pairs that yield
premium neutral option combinations, and represents the extent to which
EUR/AUD needs to move for a given AUD rally for the long/short option spread to
start losing money. Put differently, the isopremium line represents an option
implied beta between the two assets, which in this case seems to be significantly
F O R E I G N
higher than the historical beta. No transaction costs.

T O
58
BARRIER OPTIONS
A call (or put) spread can be used to replicate the

The most common barrier options include: At-expiry payout of an at-expiry barrier option
digitals, One-touches, Reverse knock-outs (RKOs),
Reverse knock-ins (RKIs), and Range Binaries.
RKOs/RKIs differ from standard KO/KI Options in
that their barriers are in the money relative to the
strike.
OP TI O N S
Barrier options provide the investor with known

upside and downside at trade inception. Although
people refer to these at times as short gamma
trades, this is a misnomer; rather, they are minimal
E XC H AN G E
tail risk trades.

A basic at-expiry digital option can be approximately
replicated through a call (or put spread). For
Replicating an at-expiry digital payout requires a
example, if we want to replicate an at-expiry digital notional of: Payout / ( / K* )
F O R E I G N
with a $1 mm payout if USD/JPY is below 85 at

expiry, we would buy an 85.01 / 85.00 put spread At Exp Vanilla Vanilla
and size the notional such that the payout equals $1 Digital Option 1 Option 2
mn. In this case, Notional = $1mn/.01 (pip in Option Type USD put USD put USD put
T O
JPY)/85 = $8.5 bn of notional. Strike 90 90.01 90.00

Spot 96 96 96
Quantity (USD, mm) 1 9,000 9,000

Price(%) 15.25% 1.140% 1.3750%
BS TV (%) 18.60%
* K is the strike of the option
59
AT-EXPIRY-DIGITALS
Notice that the USD/JPY at-expiry-digital put price is

The Price of an at-expiry digital is discounted to
the Black-Scholes price
below the Black-Scholes (constant implied vol) price
why is this? At Exp Vanilla Vanilla
Digital Option 1 Option 2
As USD/JPY moves lower, the structure becomes
Option Type USD put USD put USD put
incrementally shorter vega. The intuition behind this Strike 90 90.01 90.00
is that once the option is sufficiently in the money, 96 96 96
OP TI O N S
Spot
Quantity (USD, mm) 1 9,000 9,000
any increase in volatility will not increase the value Price(%) 15.25% 1.140% 1.3750%
of the option if USD/JPY continues downward, as the BS TV (%) 18.60%
maximum payout is still 1; on the other hand, it

E XC H AN G E
increases the chances of ending up with a 0 payout.

The structure becomes short vega at lower levels
The risk reversal is bid for USD puts, meaning the
of USD/JPY
market wants/needs Vega as Spot goes lower. Buying
a product which makes one shorter (or less long) of Delta PNL Incremental Theta Vega
F O R E I G N
Vega as we move in the direction where Vega is in USD/JPY (MM) (k) P/L (k) (k)
demand should mean the structure trades lower 16% 114.29 0 -159 -16 0 4
12% 109.09 0 -143 -26 0 5
relative to BS. Buying this Option from a dealer gives
8% 104.35 -1 -117 -45 0 7
him a risk position with properties he would pay a 4% 100 -1 -72 -72 -1 10
T O
premium for through another structure in the 0% 96 -2 0 0 -1 11

-4% 92.31 -3 108 108 0 9
market. By the Non-Arbitrage Principle, then, the fair -8% 88.89 -5 258 150 0 0
value of the Digital in this case, must be below BS -12% 85.71 -5 445 187 1 -17
-16% 82.76 -4 608 163 1 -24
Value.
The structure becomes short vega

as USD/JPY sells off
60
AT-EXPIRY-DIGITALS
The price discount to BS decreases in lower strikes. Lower-strike USD/JPY at-expiry-digital puts trade
at a lower premium to BS than higher strikes,
This is a function of how quickly the structures lose
since vega turns negative more quickly in higher
their Vega as spot moves lower. The higher-strike strikes
option becomes shorter vega more quickly as 95-strike digital put 91-strike digital put
USD/JPY sells off and therefore is priced at more of a Delta PNL Vega Delta
discount to BS than the 91-strike. USD/JPY (MM) (k) (k) (MM) PNL (k) Vega (k)
OP TI O N S
16% 114.29 0 -332 3 0 -168 2

USD/JPY digital calls, on the other hand, trade above 109.09 -1 -309 6 0
12% -155 4
the BS price. Just as being short Vega in the part of 8% 104.35 -1 -264 9 -1 -132 6
4% 100 -3 -169 12 -1 -89 9
the skew where implied vols are bid is detrimental to
0% 96 -5 0 7 -3 0 12
the value of the structure (hence cheapening it 92.31 -7 247 -12 -5
E XC H AN G E
-4% 156 8
relative to a BS price), being short Vega where vols -8% 88.89 -4 474 -22 -7 386 -9
-12% 85.71 -2 573 -14 -5 620 -23
are less bid than ATM implieds (in our case, in -16% 82.76 -1 615 -8 -2 734 -15
USD/JPY upside strikes), then the structure will trade
at a premium to BS. One-Touches trade at less of a discount to BS than
F O R E I G N
do at-expiry-digitals
At Exp One Vega
Digital Touch At-Exp One-
Option Type USD put USD put USD/JPY Digital Touch
Strike 90 90.00
T O
Spot 96 96.00 8% 104.35 7 12

Quantity (USD, mm) 1 1 4% 100 10 19
Price(%) 15.25% 36.50% 0% 96 11 27

BS TV (%) 18.60% 37.80% -4% 92.31 9 21
-8% 88.89 0 0
-12% 85.71 -17 0
-16% 82.76 -24 0
61
AT-EXPIRY-DIGITALS AND ONE-TOUCHES
While At-Expiry Digitals pay out only upon expiry, One-Touches trade at twice the price of At-Expiry
One-Touches pay out as soon as the strike is Digitals
breached. Notice that One-Touch is almost exactly At Exp One
twice the cost of the At Expiry Digital. There should Digital Touch
Option Type USD put USD put
be some intuition in this: imagine an At-Expiry Digital Strike 90 90.00
Spot 96 96.00
right at the money -- its price should be near 50%.
Quantity (USD, mm) 1 1
OP TI O N S
The One-Touch with Spot on top of the barrier has Price(%) 15.25% 36.50%
BS TV (%) 18.60% 37.80%
paid, so its worth 100%.
One-Touches, as with At-Expiry Digitals, trade at a

One-Touches trade at less of a discount to BS than
discount to Black-Scholes in USD puts / JPY calls;
E XC H AN G E
do At-Expiry Digitals
however, they trade at less of a discount. The Vega
framework that we used before applies here as well. Vega
At-Exp One-
As with the At-Expiry Digital, the One-Touch loses USD/JPY Digital Touch
Vega as USD/JPY declines, hence the reason for the
F O R E I G N
8% 104.35 7 12
discount to BS. However, because the structure pays 4% 100 10 19
out once the strike is reached, the 0 vega no longer 0% 96 11 27
-4% 92.31 9 21
matters for those scenarios. As a result, there is less -8% 88.89 0 0
of a discount than in the At-Expiry Digital. -12% 85.71 -17 0
T O
-16% 82.76 -24 0

62
USING RKOS AND RKIS TO TRADE A DIRECTIONAL VIEW

One can trade the call or a put with a reverse knock-out (RKO) Out-of the-money Gold calls are very well bid
or a call or put spread where the further OTM strike has a relative to puts
reverse knock-in (RKI) rather than just a call or put spread to
Implied Vol
gain leverage. In either case, the investor is selling expensive
upside strikes to fund the long call position. 40
Such a trade is ideal in assets where implied volatility skews in 35

the direction of the trade are rich relative to expected /
historically exhibited volatility 30
OP TI O N S
Calls in Gold/USD are good candidates to express through call

spreads with RKIs, as the skew tends to be rich in favor of Gold 25
upside. For example, rather than buying the vanilla call
spread, where we buy a call struck at 1145 and sell the 1250- 20
strike call, one could sell the 1250 strike with a reverse knock- 865 1065 1265 1465 1665
E XC H AN G E
in, i.e. the 1250 strike that we have shorted does not knock in
Strike
until 1350. Because of the rich skew, we can buy the call
spread with RKI for only 8bp more than the vanilla call spread.
The structure with the RKI has much more upside potential
provided that spot remains below 1350. making call spreads with an RKI attractive
F O R E I G N
The call spreads with RKIs offer attractive upside 210 call spread
call spread w / RKI
for a relatively low increase in up-front cost, as contingent RKI P/L
we are selling a higher skew 160
max contingent
110
T O
Tenor K1 K2 RKI cost payout max payout

call
6M 1145 1250 3.31% 6.2% 6.2%
spread 60
call spread
w/ RKI 6M 1145 1250 1350 3.71% 14.5% 5.7%
10
-40
1100 1150 1200 1250 1300 1350
Spot
63
RKOS AND RKIS TO TRADE A DIRECTIONAL VIEW
Gold typically delivers far less vol in rallies relative to sell-offs

Gold skews are typically bid for calls over puts, but than is priced in by risk-reversals
Realized skew defined as UP realized DOWN realized vol, where UP realized
realized volatility in spot rallies vis--vis sell-offs vol is computed using positive daily spot returns only over any lookback
window , and DOWN realized vol is computed off negative daily spot returns
almost always disappoints option market over the same window
expectations. In other words, gold rallies are rarely as

volatile as options seem to expect, and realized skews
OP TI O N S
usually end up coming in under implied skews.
This means that returns on bullish gold investments
can be improved by fading high strikes through call

E XC H AN G E
spreads, RKOs or butterflies. History suggests that this

has indeed been the case. Buying gold call spreads has
Fading high strikes in gold through call spreads has typically yielded
on an average been a better RoI trade in gold rallies higher RoIs than calls alone
Histogram of RoIs from systematically buying and holding-to-expiry 3M ATM calls
F O R E I G N
than buying calls outright, even though the right tail and 3M ATM / 25D call spreads in gold, contingent on gold rallies. Note that the call
spread RoI distribution has a higher mean than the outright call RoI distribution,
of the P/L distribution for the latter is obviously even though the right tail for the latter is obviously thicker. Data since Jan-06
thicker.
T O
Current levels are attractive for initiating short skew

trades. Risk-reversals are bid for gold calls, both on

an absolute basis as well as adjusted for the level of
base vol.
64
Agenda
Basics of options 3

OP TI O N S
Volatility 26

E XC H AN G E

F O R E I G N

T O
6
VOLATILITY AS AN ASSET CLASS
What if you have a view on volatility, but no view on

USD/BRL
USD/BRL Implied
Implied vs.
vs. Realized
Realized Vol:
Vol:
spot? Implied
Implied volatility
volatility too
too expensive
expensive
Volatility Trading is profiting from a discrepancy
25
between implied volatility and realized volatility or in
USD/BRL 2m Imp Vol USD/BRL 2m Realized Vol
changes in implied volatility
23
In Vanilla Options the two primary ways to profit from
OP TI O N S
volatility trading
21
Gamma Trading
Vega Trading
19
E XC H AN G E
In Exotic Options, there are various structures that can

be used to express a volatility view. The most basic:
17
Forward Volatility Agreements
Volatility Swaps
15
F O R E I G N
13
T O
11
4/13/2009 5/13/2009 6/13/2009 7/13/2009 8/13/2009 9/13/2009 10/13/2009
Source: JP Morgan
66
GAMMA-THETA TRADEOFF
Black Scholes Greeks

Theta Gamma
Non-dividend paying asset
Spot price = S ln(S/K) + (r + 2 / 2)T S<K
d1 =
Strike = K T
Volatility = ln(S/K) + (r - 2 / 2)T
d2 = S=K
Time to expiry = T T
2
Interest rate = r x
N' (d1 ) 1 -
Gamma, = , where N' (x) = e 2
S T 2 S>K
OP TI O N S
x x2
SN' (d1 ) 1 -
Theta, =
2 T
rKe -rT N(d 2 ), where N(x) =
-
2
e 2
Gamma Trading: From Math to English

Net P/L from delta hedging an option
E XC H AN G E
1
N S
2

, the first term inside the summation, is called
Assuming constant volatility, P/L in one time step t is given by i
Si
realized variance.
2 i = 1
1 2 +
( S) ( t)
2 2, the second term inside the summation, is called implied
If interest rate r is assumed to be zero, then algebraic manipulation variance. Implied variance (or rather its square root) is quoted in
of the expressions for gamma and theta shown alongside yields the the option market, and is the that is plugged into the BS equation
F O R E I G N
following relationship: for option pricing at trade inception

1
= S 2 2
2 The net P/L of a long delta-hedged option is positive when the
expression inside the parentheses is greater than 0 i.e. realized
The one step P/L expression above then simplifies to: variance is greater than implied variance.
1 2 S
2
2 The square root of variance is called volatility. It is a convention
S (t)
T O
2 S for market participants prefer to think of gamma trading P/L in terms

of volatility than variance. Hence a gamma buyer is said to make
money if realized volatility is greater than implied volatility.

The above expression can be easily extended to give the P/L from delta Conversely, a gamma seller makes money when realized volatility
hedging over the lifetime of the options turns out to be less than implied volatility.
1
N S
2
2 iSi2 i
Si
2 (t)

Finally, do NOT forget the gamma term in the expression. Gamma is
not a constant quantity, and does influence P/L (more on this later)
i =1
67
BASICS OF GAMMA TRADING
Convexity of an option Gamma P/L from delta hedging an option

P/L (JPY pips)
7
Positive convexity means the option
2
1 = 0 + 0 *dS
6 outperforms the delta-equivalent position p1 = p0 + ( 0 *dS+ 0 *dS /2)
in spot for both UP and DOWN moves 2
5 P/L = 0 *dS /2
4
3 ( 0 + 1 )/2 = 0 + 0 *dS/2
2
OP TI O N S
Option value po
1 Payout at expiry
Delta-equivalent amount of spot
0
-1
o
96 98 100 102 104 106 108 So S0 + dS
E XC H AN G E
USD/JPY spot
Deriving gamma P/L Gamma P/L does NOT come free!!!!

1. Spot is initially S 0, option is worth p 0, delta and Option price p is a function of spot price (S), volatility (), time to expiry (t),
gamma are initially 0 and 0 respec tively home interest rate (rH) and foreign interest rate (rF)
F O R E I G N
2. Spot inc reases from S o to S o + dS A standard Taylor rule decomposition of changes in option price as a result of
3. Delta inc reases from 0 to 0 +0*dS moves in these variables can be written as follows:
4. Average delta avgtherefore is 0 +0*dS/2 p p p p p 1 2p 2

p = S + + t + rH + rF + S + .....
5. New premium p 1 = p 0 +avg*dS S t rH rF 2 S 2
2
6. p 1 = p 0 + 0*dS +0*dS /2
T O
2
7. P/L of long option position = 0*dS +0*dS /2 DELTA VEGA THETA RHO GAMMA
8. P/L of short spot position = - 0*dS The antithesis of gamma is THETA, often referred to as gamma rent. Theta is
9. Net P/L of long delta-hedged option = 0*dS /2
2 the rate at which an option decays i.e. the P/L bleed of a long option position
simply because of the passage of time.
Note that P/L of the delta-hedged option depends
Note that the gamma trading construct shown earlier assumes instantaneous
ONLY on the MAGNITUDE of the spot move dS, not
spot moves. In practice, sizeable spot moves occur only over a period of time.
its direction (i.e. the sign). This is what is commonly
Hence the option buyer has to pay away rent everyday in the form of theta in
referred to as volatility trading.
order to be long gamma. If spot moves over the life of the option do not
outweigh its time decay, gamma trading will result in negative P/L.
68
WHAT DOES AN OPTION TRADER DO WITH HIS DELTA?
1M Call option delta hedged to maturity

OP TI O N S
E XC H AN G E
F O R E I G N
T O
Because we delta-hedge the option to maturity, and the option expires

worthless, naked option P/L is exactly equal to initial option price
multiplied by option notional
Realized volatility calculated using spot moves turns out to be 14.5
(more on this on the next slide), which is greater than the implied
volatility of 10.6 at entry. No wonder then that buying gamma turns out
to be a profitable venture.
69
TRACKING VOLATILITY VALUATIONS
Implied / realized volatility ratios are a commonly accepted and widely used approach G10 gamma matrix
to tracking richness/cheapness of front-end vols
Plotting implied/realized ratios along with implied vol z-scores on the same chart
provides a better perspective on the trade-off between the richness / cheapness of
implied vols relative to history and to realized vols

The theme at the front-end of G10 vols seems to be that gamma in USD-pairs look
good value given the sharp dollar rally in play at present. As the table shows, buying
OP TI O N S
3M delta-hedged straddles in USD-majors has been a winning trade over the past
month.
EUR-crosses on the other hand appear good sells, largely because moves in the
crosses tend to be muted during dominant dollar moves.

AUD/USD is an interesting gamma buy based on valuations. Given the impending
E XC H AN G E
turn in the rate cycle and in Australia along with, long AUD vol seems to be a
compelling story.
G10 currency pairs ranked in order of 1M Normalized VRP* Gamma performance in the USD-majors over the past month
Monthly P/L (10/15/08-11/14/08) and 6-month statistics for rolling monthly P/Ls
from short 1M straddles* in various USD-pairs, bp of USD notional
F O R E I G N
inf.
Ratio 5th 95th
return avg stdev (ann.) m in %ile m edian %ile m ax
AUD/USD -253 -230 359 -2.2 -904 -758 -128 56 62
EUR/USD -69 -37 68 -1.9 -129 -119 -30 37 46
T O
GBP/USD -274 -69 113 -2.1 -250 -227 -23 23 26

NZD/USD -156 -150 204 -2.5 -511 -434 -120 58 90
USD/CAD -110 -46 115 -1.4 -230 -209 6 44 45

USD/CHF 145 24 68 1.2 -56 -46 11 120 144
USD/JPY 75 -19 109 -0.6 -209 -172 -2 95 111
USD/NOK -99 -67 121 -1.9 -276 -236 -50 49 53
USD/SEK -56 -38 90 -1.4 -205 -171 -4 32 34
*Assumes daily delta-hedging and no transaction costs
70
VOLATILITY SWAPS
As mentioned earlier in the presentation, delta- In a trendless market (left-had chart below), we can
hedged straddles allow one to approximately monetize monetize realized volatility via a delta-hedged straddle,
the difference between implied and realized volatility but in a trending environment, we lose our gamma along
in a non-trending environment. However, in a trending the way.
environment, we lose gamma and can no longer
103 120
effectively monetize the difference between implied
and realized volatility. 102
115
101
One solution to the problem is to own a series of 110
OP TI O N S
100
strikes, thus providing a roughly constant gamma
105 RMS vol = 22.8%
profile. A more efficient solution is to own (or sell) a 99 RMS vol = 16.5%
Mean-adj. vol = 16.9%
volatility swap. 98
Mean-adj. vol = 16.9%
100
The payout of a volatility swap is simply: 0 5 10 15 20 0 5 10 15 20

(Realized Vol Preset Vol) x vega amount
E XC H AN G E
Owning a series of strikes in weights inversely proportional

The notional quantity is expressed in vega amounts to the square of the strike gives an approximately constant
E.g. Sell $500,000 of 3M vega at 10.0% gamma profile. Owning a volatility swap gives a payout with
an exactly constant gamma profile.
Payout = (Realized Vol Preset Vol) x vega amount
F O R E I G N
The volatility is typically determined by a set number

of fixings
E.g. Spot rate sampled every business day at
exactly 11:00 AM NYT from inception to expiry
The advantages of a volatility swap versus a delta-
T O
hedged option:
- No need to delta hedge

- A constant gamma and vega profile across strikes
- Ability to cleanly monetize the difference between
implied and realized vol
71
FORWARD VOLATILITY AGREEMENTS (FVAs)

Forward Volatility Agreement (FVA) is the right to buy or Forward volatility vs. Spot/ Implied Volatility Curves
sell a fixed tenor option at a fixed point in the future. 13.0
2 n,m ndaycount = 2 n+m (ndaycount + mdaycount ) ( 2 m mdaycount )

Spot Implied Volatility
12.5 3M Forw ard
6M forw ard
12.0
where n and m are either months or years, i.e 1,2 is
Volatility (% )
11.5
1m, 2m forward
11.0
Forward Vols are often considered to be a systematic
10.5
buy when Spot Vol Curves are inverted, or downward
OP TI O N S
sloping and systematic sells when Spot Vol Curves are 10.0
steep, or upward sloping. The reality is that neither 9.5

proposition is correct. Current Realized Vol, Structural 1 3 6 12
Tenor (M)
concerns and the Macro regimes effect on the overall
E XC H AN G E
level of Volatility all need to be assessed when Forward Volatility Grid

determining whether Forward Vol should be bought or
sold. Remember, there is no implicit arbitrage in the Vol
Market simply because of the shape of the Implied Vol
Curve. The Forward Vols derived from the Spot Vol
F O R E I G N
Curve, are the markets assessment of where Vol will

need to be in X amount of time forward, given the
amount of Vol expected over some longer period of time
as priced by longer term Implied Vol.
T O
The FVA provides exposure to forward implied volatility

but without having to actively manage the Delta and

Gamma. If the structure was created synthetically using
Vanilla Options (which would be a portfolio of 3m and
6m Straddles for a 3m in 3m time FVA) it would be in
gamma neutral weights at inception, hence less 3m and
more 6m, giving the net position the Vega exposure.
72
RELATIVE VALUE, CORRELATION, AND THE MACRO ENVIRONMENT

Link between volatility and correlation: when the realized
volatility of a particular currency, say USD, goes up, it tends AUD/USD and USD/JPY exhibit high correlation between
to do so across the board. In other words, the USD moves implieds but not realizeds
relative to all other currencies. In these cases, all USD pairs
30
tend to move in the same direction, and as such USD 1Y AUD/USD - USD/JPY implied vol spread
Complex vols should all be moving in tandem as the 3M realized vol spread
25
individual option markets price volatility higher for each
20
cross. When a complex is driving the price action relative
to other assets, we say complex vol or correlations are
OP TI O N S
15
performing. When one or more of the pairs is reacting more
idiosyncratically, outside of the behavior of the rest of the 10
complex, we say they demonstrate dispersion. 5

E XC H AN G E
Most vol studies show that implied vols tend to rise 0

together. However, realized vols are not nearly as Oct 08 Jan 09 Apr 09 Jul 09 Oct 09
correlated. It is here that the true statistical arbitrage is
affected as we attempt to capture idiosyncratic behavior on
the realized volatility of one asset relative to another, while
F O R E I G N
remaining roughly vega neutral (macro volatility risk

neutral) in our structured portfolio of implied vols.
Implied vol are more highly correlated to each other than

realized vols. It is exactly for this reason why one sees
T O
more stable implied vol ratios or spreads even as realized

vol spreads diverge. Look at the performance of the AUD vs

JPY again above. There seems to be minimal tail risk in the
sense that the realized vol spread in the current regime has
not dipped below the implied spread. Also notice the
asymmetry in the payoff - it is well in favor of holding AUD
vol relative to JPY Vol.
73
RELATIVE VALUE VEGA REPORT
74
Global FX Strategy
November 5, 2010
Arindam Sandilya (1-212) 834-2304

JPMorgan Chase Bank NA
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Global FX Strategy
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JPM Introduction To FX Options

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Global FX Strategy

Introduction to Foreign Exchange Options

www.morganmarkets.com/GlobalFXStrategy JPMorgan Chase Bank NA

Option Pricing Theory 13

Option markets as a source of intelligence for spot markets 34

Measuring risks in option portfolios 43

Directional trading using options 55

Trading volatility as an asset class 66

CALL OPTION PAYOFF AT EXPIRATION

Yields payout in numeraire currency pips per unit of asset

The linear profile shown below therefore only holds when

An option that delivers a linear payout profile in the asset

PUT OPTION PAYOFF AT EXPIRATION

Yields payout in numeraire currency pips per unit of asset

The linear profile shown below therefore only holds when

An option that delivers a linear payout profile in the asset

OPTION PREMIUM QUOTATION

Conventions Conversion from one convention to another

Option premium can be expressed in %AC = %NC x Strike

Percent of numeraire currency notional (% JPY)

numeraire currency (USD per JPY)

Example AC per NC = %AC

call (spot 90.25) in $10MM may be expressed as:

4. $ 0.00045250 0.00046333 per option in JPY per unit USD notional is

INTRINSIC VALUE AND TIME VALUE

PAYOUT vs. P/L PROFILES

P/L of an option differs from its Long Call Short Call

option trade makes or loses p

Breakeven spot rates: Spot rate Spot rate at

Example Long Put Short Put

1) % USD = % EUR * Spot / Strike P

PUT CALL PARITY

Buy a call + sell a put = Synthetic long forward

Put-Call Parity Relationship for any strike K Implications

- rdT (plug F = K in the second put call parity

BASIC OPTION STRATEGIES

Call Spread Put Spread Risk-Reversal Straddle

Strangle Butterfly Condor Calendar Spread

question, a carry trader stands to pocket the difference

instance is to buy 1M ATMF (i.e. strike = forward = 1.7603)

1.75) USD puts/BRL calls

Option Pricing Theory 13

Option markets as a source of intelligence for spot markets 34

Measuring risks in option portfolios 43

Directional trading using options 55

Trading volatility as an asset class 66

OPTION PRICING BASICS

Consider a one period call option with the following characteristics:

Spot price = 100

Exercise price = 100

Volatility = 20% per period

Short-term interest rate = 1% per period

PRICING THE CALL OPTION

Step 1: Determine the distribution of spot price at expiration

S = 100 Strike = 100

Step 2: Value the option at each possible spot price at expiration

PRICING THE CALL OPTION (CONTD)

Step 3: Calculate the expected value of the option

Step 4: Calculate the present value of the option

PRICING THE CALL OPTION (CONTD)

What if a different market participant has a different reading of movement probabilities?

Present value of the option is then

VOLATILITY IS AN IMPORTANT DETERMINANT OF OPTION PRICING