FX Best Execution PracticesProprietaryThree Best-Execution Strategies for Vanilla FX Options

May 20, 2010by John Galanek

FX Options Trading Strategies

Here are three best-execution FX options strategies to improve your trading success.

1. Always Exchange Delta

If you are using vanilla currency options to express a directional view in the underlying, there is one thing you should know: Nothing will light up your FX Salesperson’s eyes more than hearing the words, “please execute live, no delta exchange.”

Here is an example:

You are buying €100 million, three-month 25 delta EUR calls / USD puts because you have a view that EURUSD is going to move higher soon as the talk about Greece defaulting on its debt subsides.
Spot EURUSD is 1.2550 and the three month forward is 1.2559.
The 25-delta strike, using a volatility of 16.0, is 1.3287. We can verify this with a Black-Scholes pricing tool of choice.
By not exchange delta, you are allowing your Salesperson to set spot, and it will never be in your favor, and you will pay more premium than you should for the 25-delta strikes.
You should exchange delta so that you get a market spot rate and hence pay the correct premium for the option, not the inflated premium that will be charged if your salesperson is allowed to set spot based on your fill of the hedge unwind.

After you exchange delta, you simply execute a spot trade (or forward if you exchanged forward delta) with another counterparty after the trade. This is far more transparent and leaves fewer degrees of freedom on your trade.

Remember, taking a few extra minutes of market risk is always a better deal than taking a 100% probability of paying an extra premium for the same option.

2. Know the FX Swap Points

When your sales person starts talking about using “depo” or deposit rates in the Black-Scholes model to arrive at the FX swap points to value the option, a bell should go off in your head.

The FX Swap points to August 25 are the FX Swap points to August 25 – period. The calculation of FX swap points does not change because you are pricing a vanilla option. This little subtlety allows the salesperson to shade the swap points in their favor, simply because both currency “depo” rate fields exist on most Black-Scholes pricing models.

Deposit rates are needed, but only for discounting the premium of the option, not for calculating the FX Swap points. Using solely the depo rates and ignoring the basis swap will misprice the FX swap points…and it is NEVER in your favor.

That brings us to the next important variable – the deposit rate used to discount the premium on your option.

3. Use the Interbank Deposit Rates to Calculate the Option Premium

Insist on using the same deposit rate for the option premium that is used in the interbank market. On your Bloomberg terminal, type “BBC ” and calculate the deposit rate for your premium currency.

Similar to FX Swap points, you should know what this is for your value date before going into the market and executing an option trade. This is especially important in longer-dated options, or options in which the premium is paid or received in a high-yielding currency.

Contact FXTransparency to learn more about our FX consulting services.

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