Fx options payout

OPTIONS TRADING.

FX Options: The Elephant in the Room.

How to Generate Significant Returns from Anomalies and Biases in the FX Option Market.

Premium vs Payout.

The phrase ‘the elephant in the room’ is usually used to refer to a fact which is glaringly obvious once pointed out, but to which people have been oblivious for some time. There is an elephant in the FX options room.

FX options are a huge market. The latest Bank of International Settlements survey in 2013 found that there was over 300 billion USD worth of flow every trading day. Spreads are tiny and liquidity is large. So how can there possibly be any systematic bias or predictable pattern which has not already been traded away?

And yet, there is. If one were presented with a financial instrument which on average pays back only half of what it cost, one would call it either a bad deal (if bought) or an opportunity (if sold). Or if one were presented with an insurance contract which on average paid back 50% more than its premium, it would be highly desirable to buy, but not good to sell. This situation is exactly what we find with some FX options.

Let us take a look at the data. Below, in Figure 1 and Figure 2, we have plotted the average payout to FX put and call options 1 , divided by the average premium, throughout history since the start of the market. The 34 most liquid currencies were used. The options were the most liquid type, At-the-Money-Forward puts and calls. Additionally, we included trading costs.

If options were perfectly ‘fairly’ priced, we would expect to see that all of these data points hovered at about 100%. If, more realistically, we expect trading desks to make a profit, we might anticipate that they would all be a little less than 100%. But that is not what we see at all.

Figure 1: Payout-to-premium ratio for ATMF call options Source: Bloomberg and Commerzbank.

Figure 2: Payout-to-premium ratio for ATMF put options Source: Bloomberg and Commerzbank.

1 Note that these are puts and calls on the exchange rate, ie, on the base currency.

Digital Option.

What is a 'Digital Option'

A digital option is an option whose payout is fixed after the underlying stock exceeds the predetermined threshold or strike price. It is also referred to as a "binary" or "all-or-nothing option." A digital option depends only on one proposition, which is whether the underlying asset expires in the money at the expiration date. If the underlying asset expires in the money, the option is automatically exercised.

BREAKING DOWN 'Digital Option'

The value of the payout is determined at the onset of the contract and doesn't depend on the magnitude by which the price of the underlying moves. So, whether an investor is in the money by $1 or $5, the amount he receives will be the same. Since digital options are fairly simple to understand, this type of option may be more attractive than plain vanilla European or American options.

Payout.

What is a 'Payout'

A payout is the expected financial return from an investment over a given period of time; it may be expressed on an overall or periodic basis as either a percentage of the investment's cost or in a real dollar amount. Payout can also refer to the period of time in which an investment or a project is expected to recoup its initial capital investment and become minimally profitable. It is short for "time to payout," "term to payout" or "payout period."

BREAKING DOWN 'Payout'

Payout Ratio as a Measure of Distribution.

There are two main ways companies can distribute earnings to investors: dividends and share buybacks. With dividends, payouts are made by corporations to their investors and can be in the form of cash dividends or stock dividends. The payout ratio is the percentage rate of income the company pays out to investors in the form of distributions. Some payout ratios include both dividends and share buybacks, while others only include dividends.

For example, a payout ratio of 20% means the company pays out 20% of company distributions. If company A has $10 million in net income, it pays out $2 million to shareholders. Growth companies and newly formed companies tend to have low payout ratios. Investors in these companies rely more on share price appreciation for return than dividends and share buybacks.

The payout ratio is calculated with the following formula: total dividends / net income. The payout ratio can also include share repurchases, in which case the formula is: (total dividends + share buybacks) / net income. The cash amount paid out to dividends can be found on the cash flow statement in the section titled cash flows from financing. Dividends and stock repurchases both represent an outflow of cash and are classified as outflows on the cash flow statement.

Payout and Payout Period as a Capital Budgeting Tool.

Payout may also refer to the capital budgeting tool used to determine the number of years it takes for a project to pay for itself. Projects that take a longer period of time are considered less desirable than projects that take a shorter time period. The payout, or payback period, is calculated by dividing the initial investment by the cash inflow per period. If company A spends $1 million on a project that saves $500,000 a year for the next five years, the payout period is calculated by dividing $1 million by $500,000. The answer is two, which means the project will pay for itself in two years.

Options Profit Calculator.

Options Profit Calculator provides a unique way to view the returns and profit/loss of stock options strategies.

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