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Options

Intrinsic value and time value
The price of an option consists of two parts, the intrinsic value and the time value. The intrinsic value is defined as the difference between the strike price and the underlying FX spot rate (American style) or FX forward rate (European style). It represents the value if exercised.

For example a European call option with a strike price of 1.50 GBP/USD and spot at 1.60 GBP/USD on the expiry date would have an intrinsic value of 0.10 USD. Therefore the buyer would certainly exercise the option.

However, the value of an option during its whole lifetime will always be above the intrinsic value. This value represents the uncertainty until expiration, the risk of the Underlying asset and the riskless return of the currencies.
The following factors are included in the time value:

1. The spot price of the currencies
2. The strike price of the option
3. The riskless interest rate of both currencies
4. Time to maturity
5. The volatility between the involved currencies.

Volatility is without a doubt the most important factor of the above mentioned. It is a measure of movements in the price of the underlying. A high volatility increases the risk of the option and the uncertainty about future price movements but increases also the probability that the option is in the money at expiration. Therefore an increase in volatility causes an increase of the option price of both types, call and put options.
The following table gives a summary about how a change in one of the five factors mentioned above could affect the option price.

The proportion of time value as part of the option price is not always the same over the life of the option. The time value decays at an accelerating rate towards maturity with little decay at the beginning of longer-term options. Therefore buying a longer-term option would give a better value than purchasing an option with a shorter maturity. The premium is higher as well.

The time value also depends whether the option is in, at or out of the money. At the money options have the highest time value because the uncertainty of moving into the money and therefore for exercising the option is very high (50:50). The expectation about movements of in the money and out of the money options are more certain, resulting in lower time values.

Implied Volatility
Implied volatility is the volatility that the market assumes for a current option price. It can be determined as value that has to be input into an option price model (e.g. Black-Scholes) in order to generate the current market price of the option. Implied Volatility can be used as a measure for the valuation of an option or of how market participants expect the exchange rate to fluctuate in the future.
Basically implied volatility will give the price of an option; historical volatility will give an indication of its value.

Delta
The delta of an FX option is the change in price of an option, relative to a change in the foreign exchange rate.

Any change in a factor that can influence the potential exercise causes a change in the delta. This could be a change in the underlying FX rate, in the volatility, riskless interest rate or passing time (see in table how these factors influence the option price).
The delta of an at the money option is always 50% because the probability of exercising is 50:50. Deltas for in the money and out of the money options have to be calculated but generally a deeply out of the money option will have a delta very close to zero and an in the money option will have a delta very close to 1.

Types of Option Trades

Effective Factors