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Individual Forex Option Trading
 
I. Getting Started with Forex Option
You want to buy a house with a price tag of RMB1 million, but you fear the price may drop if you buy it now and the price may rise if you don’t. Suppose the property developer lets you buy the house for RMB1 million in 3 months by making a down payment of RMB20,000, whether the housing price rises or not. In this case, your purchase right is an option.
You can buy the house for RMB1 million and sell it for RMB1.2 million if the house is worth RMB1.2 million three months later. Excluding the RMB20,000 outlay, you earn RMB180,000. If the price drops to RMB950,000 in three months’ time, you can buy it for RMB950,000 then. Plus the RMB20,000 outlay, you pay RMB970,000 for the house, which is still lower than the original RMB1 million price tag.
Therefore, an option is defined as the right of the buyer under an option contract to buy or sell an agreed quantity of specified objects at an agreed price at a future date or over a future period of time. In this context, the buyer has the right rather than the obligation to exercise or not exercise contractual rights.
In the above example, you have the right to buy the property, and your right is referred to as a ‘call option’. Your right becomes a put option if you're allowed to sell the property for RMB1 million in three months after initially paying RMB20,000.
In the financial market, option contracts with foreign exchange as underlying assets are referred to as forex option contracts. In forex option trading activities similar to the above example: The RMB1 million worth property is equivalent to the underlying exchange rate; the agreed purchase price of RMB1 million is the 'exercise right’; the RMB20,000 payment for acquiring the purchase right is referred to as ‘option money’ or ‘option premium’; the right to buy the house at an agreed price after paying an extra sum of RMB20,000 is ‘call option’; and the purchase right can be exercised in three months, which is called the ‘maturity date’.
In 1982, the US Philadelphia Stock Exchange (PHLX) traded the world’s first forex option contract. Since then, option trading has burgeoned as trading in financial derivatives has grown. Statistics from the American Futures Industry Association (FIA) showed that less than 100 million option contracts were traded in 1973 when option trading began life, and the figure soared to 5.938 billion in 2005.

II. Basic Concepts
Option:
An option is defined as the right of the buyer under an option contract to buy or sell an agreed quantity of specified objects at an agreed price at a future date or over a future period of time. In this context, the buyer has the right rather than the obligation to exercise or not exercise contractual rights.
Option money
The buyer is required to pay a sum to the seller for acquiring the option right. The sum of payment is referred to as ‘option money’, ‘option premium’ or ‘price of option’.
Exercise price
Under an option contract, the agreed underlying asset price is called ‘exercise price’ or ‘strike price’.
Underlying asset
Under an option contract, the specified object is referred to as ‘underlying asset’, or ‘underlying currency’ in forex options.
Maturity date
The right of an option buyer to trade underlying assets has a time limit, within which (or a specified date) the option remains valid. The date on which an option becomes due is called the maturity or expiration date. The period between the date of trading an option and its maturity date is the valid term of the option.
European option
The option holder is allowed to exercise the trading right only on the maturity date.
American option
The option holder can exercise the trading right anytime before the maturity date.
Call option
The buyer under an option contract is entitled to buy the underlying asset at the agreed price over a specified future period of time.
Put option
The buyer under an option contract is entitled to sell the underlying asset at the agreed price over a specified future period of time.
Hedging ratio δ
This ratio describes the range of forex option price changes for each change of basis point in the spot rate. The index reflects the sensitivity of forex option prices to spot rate changes.
Volatility
This index measures the range and pace of asset value changes and the degree of uncertainty about future underlying asset prices. The more volatile the underlying asset price is, the more likely the option holder will profit from higher option prices.
Exchange-traded market and over-the-counter market
Forex options are traded on two markets: the exchange-traded market and the over-the-counter market.
Exchange-traded options are traded on an exchange under standard contracts formulated by the exchange. Only members of the exchange can trade such options.
Over-the-counter options are traded outside the exchange under a contract with the amount, duration, and price agreed by the buyer and seller. Therefore, over-the-counter trading varies in customizable value and terms.

III. Investment Risks
As forex options provide high leverage, an investor only needs to pay a small sum of the option premium to obtain the same yield as he/she can from the spot market using a larger sum of money; however, the investor may lose all of the option premium in the worst case scenario. For example, an investor buys an European put option contract with the exercise price being EUR1.2892 and the maturity date being July 31, 2006. If the EUR-USD exchange rate is below 1.2892, the investor’s right to buy US dollars at the rate becomes worthless, and the investor loses the paid option money.
Therefore, investors should fully consider the possibility of loss and their risk appetites, and research the market before buying options.

IV. Operation Guide
Activation
Apply to any CMB outlet to activate the Individual Forex Option Trading feature with your identification certificate and your WMA or bank card. (Currently this application is only available for WMA holders, who only need to provide a WMA. You may obtain a WMA before the application.)
You can also activate the feature online.
Minimum trading value
The minimum value of each trade is the purchase price of an option contract.
Trading hours
The trading system is open Beijing time between 8:00am Monday and 5:00am Saturday (or 4:00am Beijing time when the American DST applies). CMB has the right to close the market and suspend trading individual forex option contracts during China’s statutory holidays, holidays in major global financial markets, or in times of emergency. The trading hours can vary based on CMB’s trading system records.
Trading channels
Currently CMB only supports forex option trading through WMAs. CMB can provide more trading channels, subject to prior notice.
Trading orders
CMB’s individual forex option contract trading system currently provides four types of orders:
Instant order:
Orders to trade options at prices currently quoted in CMB’s trading system, which become effective immediately.
Board order:
Orders to trade options at a price specified by the customer when CMB’s quote reaches the specified price. When you buy a board option, the board price is lower than the current offer rate of the option contract; when you sell a board option, the board price exceeds the current bid rate.
Stop order:
Orders to trade options at prices specified by customers when CMB’s quote reaches a specified price. For a stop-buy order, the stop price is higher than the current offer rate; for a stop-sell order, the stop price exceeds the current bid rate. Currently, CMB’s system only supports stop-sell orders.
Cancel order:
Instructions to cancel an order. This only applies to open orders. You are only allowed to sell option contracts that you have purchased and settled through CMB’s trading system.
Order term:
Once issued, an order remains valid until the trade is completed, the order is cancelled, or the trading system closes.
Trading rules
You are required to trade at least one option contract and buy USD10,000 worth options for each trade.
Settlement at maturity
The CMB trading system automatically settles the option contracts you have bought and held to maturity through the system, and pays the due sum into your account.

V. CMB Rules for Trading Individual Forex Option Contracts
Chapter 1 Basic Rules
Article 1
CMB receives your forex option trading orders through a designated channel, trades individual forex option contracts at prices published by CMB, and settles payments accordingly.
Article 2
Activating the trading service. You can trade CMB’s individual forex option contracts only when you have enabled the trading service, taken the risk assessment, and signed the Statement of Voluntarily Trading Forex Option Contracts or the Statement of Voluntarily Trading Forex Option Contracts above My Risk Bearing Capacity with CMB based on the results of risk assessment.
Article 3
Disabling the trading service. To disable the service of trading individual forex option contracts, cancel all open orders and sell out the balance of all option contracts.
Article 4
Before commissioning CMB to trade individual forex option contracts, you are required to understand the basic trading principles and rules, and you are liable for losses attributable to your own errors such as operation errors.
Chapter 2 Risk Warnings
Article 5
CMB strongly recommends you read this chapter carefully to fully and accurately understand the risks of trading forex option contracts.
Article 6
By applying to CMB for trading forex option contracts, you are deemed to have fully acknowledged and understood the related risks, and agree to bear such risks and related losses.
Article 7
Different from forex trading, forex option contract trading provides leverage that allows you to produce considerable yields at a limited cost or lose part or all of your principal within a short timeframe. Therefore, you must fully examine your own economic conditions and financial status, and decide whether to participate in such leveraged trading activities. Before trading forex option contracts, fully understand the following:
  • 1)
    Forex option contract trading incurs risks that may arise from forex trading.
  • 2)
    During the term of a forex option contract, the contract rate may vary with its underlying interest rate and is usually more volatile than this rate. You should closely track the impact of fluctuations in the underlying interest rate on the forex contract rate.
  • 3)
    CMB customizes and publishes forex option contracts for trading through its forex option contract trading system.
  • 4)
    Before trading a forex option contract, you must fully understand the contract terms.
  • 5)
    A forex option contract has a given term and its value may fall sharply as its maturity date nears. The contract becomes valueless when it carries no other exercise value upon expiry.
  • 6)
    CMB can suspend quoting or even trading without any liability due to political, economic or emergency events, or force majeure factors such as communication or trading system failures.
Article 8
The above risk disclosures are for reference only and do not cover all risks of trading forex option contracts or all possible factors that may affect the forex option contract rate. Before trading, please read CMB Rules for Trading Individual Forex Option Contracts (2nd Edition) carefully, and understand the other factors that may affect the forex option contract trading or rate. You must implement adequate risk assessment and financial arrangements to avoid heavy losses.
Chapter 3 Trading Rules
Article 9
CMB customizes forex option contracts for individual trading through its trading system. The following table lists contract specifications, which may vary according to CMB’s trading system records.

 

Currency Cross

EUR/USD

GBP/USD

EUR/JPY

AUD/USD

Underlying value (per contract)

EUR100

GBP100

USD100

AUD100

Call option

EUR call option

USD put option

GBP call option

USD put option

USD call option

JPY put option

AUD call option

USD put option

Put option

EUR put option

USD call option

GBP put option

USD call option

USD put option

JPY call option

AUD put option

USD call option

Type

European option (The option holder can exercise trading rights only on the maturity date.)

Exercise price

Specified by CMB

Term

3 months, 6 months etc.

Contract state date

Specified by CMB

Contract expiry date

Specified by CMB based on the start date and contract term

Settlement date

Contract expiry date

 

 

Article 10 Trading Price
CMB quotes the price for an individual forex option contract as follows: bid rate on the left and offer rate on the right. You buy an option contract at the offer rate and sell it at the bid rate.
Article 11 Trading Hours
CMB allows you to trade individual forex option contracts Beijing time between 8:00am Monday and 5:00am (or 4:00am DST if applicable) Saturday. Trading hours may vary according to CMB’s trading system records.
Article 12 Trading Channels
Currently CMB only allows you to trade forex options using a WMA (WMA). CMB may provide more trading channels, subject to a prior notice.
Article 13 Trading Orders
CMB’s individual forex option contract trading system currently provides four types of orders:
  • 1)
    Instant order: Orders to trade options at prices currently quoted in CMB’s trading system, which become effective immediately.
  • 2)
    Board order: Orders to trade options at a price specified by the customer when the CMB’s quote reaches the specified price. When you buy a board option, the board price is lower than the current offer rate of the option contract; when you sell a board option, the order price exceeds the current bid rate.
  • 3)
    Stop order: Orders to trade options at prices specified by customers when CMB’s quote reaches a specified price. Under a stop-sell order, the option contract is sold at a price lower than the current bid rate.
  • 4)
    Cancel order. This instruction is designed to cancel an order. This only applies to open orders.
You are only allowed to sell option contracts that you have purchased and settled through CMB’s trading system..
Article 14 Order term
Once issued, an order remains valid until the trade is completed, the order is cancelled, or the trading system closes.
Chapter 4 Settlement at Maturity
Article 15
The CMB trading system calculates the required amount of funds and expenses based on the number of option contracts you have bought and the trading price, and deducts the due amount from your account.
Article 16
The CMB trading system automatically settles an option contract you have bought and held to maturity through the system, and pays the due sum into your account on its date of maturity.
Article 17
CMB determines the benchmark price based on the closing spot price published by the Tokyo Foreign Exchange Market at 14:00 Beijing time on the date of maturity.
Article 18
For a call option, the system automatically calculates and pays the contract yield into your account on the date of maturity when the difference between the benchmark price and the exercise price exceeds zero. The option is valued at zero when the difference is equal or less than zero.
Article 19
For a put option, the system automatically calculates and pays the contract yield into your account on the date of maturity when the difference between the benchmark price and the exercise price is below zero. The option is valued at zero when the difference is equal or greater than zero.
Chapter 5 Miscellaneous
Article 20
CMB publishes trading prices for individual forex option contracts through its trading system.
Article 21
Quotes outside the trading system are for reference only and cannot be used to justify complaints against prices quoted in CMB’s trading system.
Article 22
CMB has the right to revise option contract rates from time to time and suspend quotations without any extra liability.
Article 23
The issue and completion of orders, trading time, price and type, and the number of contracts are recorded in CMB’s trading system.
Article 24
CMB has the right to stop trading individual forex option contracts during China’s statutory holidays and major global financial market holidays.
Article 25
CMB may suspend quoting or even trading without any liability due to political, economic or emergency events, or force majeure factors such as communication and trading system failures.
Article 26
CMB has the right to interpret these rules. When necessary, CMB may publish amendments or supplements to the provisions herein through its banking outlets or website, or through any other channel CMB deems appropriate, which become effective immediately.
Note:
All the contents stated above are for your reference only. Please consult the local branch of China Merchants Bank for further information. China Merchants Bank reserves the ultimate right of interpretation for the contents in this page.