FX Option Performance. Peter Billington

in percent of notional to a 1W short put strategy in EURCHF

      Anecdotally, many hedge funds do make money by selling volatility in this way. ATMF options might not be the contracts of choice; they are liquid and have relatively large premiums, but the investor might want to collect a larger premium with a more complex structure, or might want to make a payoff less likely by choosing an out-of-the-money option – see Chapters 5 and 6 on these. But the principle is the same: selling volatility makes money when the market overestimates future risk. However, this route to profit is paved with disasters. Many a hedge fund has seen literally years of steadily accrued profits evaporate in a day or two of crisis-driven market action. We see this in Figure 1.2; though the option selling strategy ends up in profit, the losses or drawdowns can be huge and sudden.11 The data set finishes in 2013, but one can imagine the effect of 2015 events when the currency peg was removed by the central bank.

      The other way that investors in general trade option markets is to buy options which they believe are undervalued – the idea behind Naseem Taleb's famous ‘Black Swan’ fund [3]. This type of strategy seeks out markets where risks seem to be underestimated and buys options which will pay out handsomely if this is true. Consider a longer dated option, say for 12M, bought in the spring of 2008 on USDJPY. The investor might have reasoned that problems surfacing in the US housing market would sooner or later cause a sharp depreciation of the USD – and they would have been right. Buying an option with a longer tenor allowed them to make money even though they were uncertain of the precise timescale.

      So clearly there is much of interest in systematic differences between premium and payoff for the investor community. However, we said that there is no magical formula for trading strategies within these pages. Why not?

      Once one considers how trading strategies would be executed, it becomes possible to understand how inefficiencies are not necessarily pots of gold at the end of financial rainbows. Imagine we identified a strategy which said that selling options of a certain type could result over time in a profit. We know, however, that sold options have unlimited loss potential, so even if the result after a few years was likely to be profitable, the risks in between could be enormous. The investor might have to tolerate a loss of 20 % in one year to average a 5 % return over several. That's not a very good risk/reward ratio on your investment. Or perhaps one might identify an opportunity to buy options and make money. In this case the risks would at least be limited, but what if the options were long term and only made money near the end of their lives? The investor would have to fund a loss for some time before it was likely he would see profit. Given that the strategies would only be expected to make money over a number of years, with profit and loss in between, there would always be a risk that in any one year they would be unlucky. In short, while we hope this book will inform investors about likely areas for further investigation, as we said before, there is no magical recipe within these pages.

      Finally, investors often buy overseas assets which have good return potential. In this case they may wish only to have exposure to the asset itself, and not to accept the FX risk. In this case they turn back into hedgers and may find utility in this book as previously discussed.

      1.5 HISTORY AND SIZE OF THE FX OPTION MARKET

      During the mid-1980s a confluence of events gave birth to the FX option market as we know it today, namely: a demand for the product, the ability to price the product, a market place to trade and, with the advent of computer power, the ability to manage risk.

      To have an option market, first it is necessary to have a liquid market in the underlying rate (usually called just the underlying) upon which the options are based. Before the 1970s, when exchange rates were in general fixed to specific values and adjusted at intervals, there was no possibility of an option in the market. But as different countries gradually abandoned the increasingly unworkable fixed FX rate regime which had been implemented after the post-war Bretton–Woods agreement, risk appeared, and the first to take note and act upon this risk were the corporations of the world. As has been described earlier, companies with income and liabilities in other countries are highly sensitive to exchange rate fluctuations and seek ways to minimise them. Corporate treasurers initially used forward FX contracts to lock in rates but then realised they could sell them if the contracts entered very negative territory, assuming a trending market, and replace them if they became close to positive once more. This crudely replicates the protective properties of an option, though it was a cumbersome and imprecise process. The idea of a product where another company took over this adjustment process was attractive. The very early currency overlay companies did exactly this, calling it option replication. As the markets started to swing wildly during the 1980s the demand for this increased. True options in FX began to be bought and sold, though the correct price for an option was hotly debated.

      Equity option traders began to use the Black-Scholes-Merton model shortly after its publication in 1973 [1] but there was at that time little thought of using it for FX contracts. In 1983 Garman and Kohlhagen published the extension to the Black-Scholes-Merton model which enabled FX options to be clearly and simply valued for the first time, as it included dual interest rates [4].

      With the demand for the product, and the ability to price it, came the distribution. The first FX option was dealt on the Philadelphia Stock Exchange in November 1982 [5]. At that time they were a small futures exchange who courageously introduced the new instrument when there was no OTC12 market at all, and virtually no other instruments available to use as pricing references. These options, consistent with similar equity products at the time, were, American-style, exercisable by the option purchaser any time up to expiry, which would have made them even more challenging to value. But clearly they showed promise; by the mid-1980s the exchange in Chicago was also actively trading contracts on FX options, and the number of boutique option houses grew.