For FX options that are traded OTC vol quotes are given on a standardised grid, e.g. expiries 1D, 1W, 1M, 3M, 6M, etc. maturity and for each of these expiries you have quotes for ATM, 25 delta Risk reversal, 25 delta butterfly, etc. This is different to listed equity index options where you have fixed dates as expiries.
The implied volatility for Options with expiries or strikes not on this grid can be computed via interpolation.
My understanding is that people usually trade the standardised expiries, since market makers would give you the best price for these, e.g. you would usually open a position with 3M expiry, but not with 3M minus 3 days. Now suppose I have some systematic strategy and I bought the 3M ATM option a few days ago and now my strategy wants to increase position in 3M ATM. Spot has not moved much, so the option I bought a few days ago still offers me a decent exposure to 3M ATM, maybe with a small adjustment factor. Is it true that buying a new 3M ATM option would be much cheaper than increasing my position in the strike, expiry pair I already have in the book, since market makers prefer to trade standardised expiries? Would people then usually open positions in New options in this case? But wouldn't that mean that you will end up with a huge number of expiries in your book if you run this strategy for a while, making it very hard to manage the book?
2 Answers
The treatment of off the run expiries differ depending on if you are a client or a counterparty in the transaction. If a client asks me for a strange date in a reasonable size I would do some simple checks (is this a non-farm payrolls day, or on some central bank meeting) and would adjust my pricing according as opposed to adjusting solely due to them asking for a 7 month option, forward or STIR product. Also, if I already have the original trade that would tend to improve the pricing. If it was abnormally large I would show a better price on a standard maturity vs something off the run as any hedging trades match better for reasons that will follow. A counterparty asking for a non-standard date in the inter dealer broker space I treat as a massive red flag (hence the better pricing for large requests for quotes on standard dates, no red flags). This is as it suggests some sort of concentration risk they have that they are unwilling to hedge with a standard date product.
Another thing to consider here is less to do with dates drifting and more to do with the underlying changing. Lets say your 25d call is now a 5delta call, the relative cost of trading deep OTM options are higher than trading options closer to the market.
Now in the FX option IDB space, you typically see the following run: 1m, 2m, 3m, 6m, 1y and 2y ATM options and 25D RR's through out the day at the market convention cut (when in doubt NYC) while the 10 delta RR and any fly being much more sporadic in the non G10 space. There are however standard dates that do trade as well in the currency and rates space, the IMM dates and they are very popular with fast money funds as you do not have the expiry drift problems you are asking about.
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$\begingroup$ Many thanks for the answer. Suppose I bought a 3M ATM call. 2 weeks have passed and the option is now a 40 delta Call. What would usually be cheaper and more common: to roll the option to a 50 delta call of the same expiry or to roll the option to a 50 delta 3M ATM. The first trade is a strike spread, but on a nonstandard expiry. The second trade is a diagonal spread as we change both strike and expiry $\endgroup$– VolwizMay 27, 2021 at 17:38
I'll caveat this to begin with by saying that i'm not an FX trader, so the below is just how i would expect it to work.
I would not expect a significant charge for trading off the standard expiries.
When people quote prices in broker markets on OTC stuff, they typically provide what are called runs, where that means a semi standarised strip of prices. The standard runs and the way they're quoted are different in different markets. In FX markets, i believe that these runs are the ATM and 25d RR and Flys, on some (arbitrary) grid of maturities. People choose stuff like 1w, 2w, 1m, 2m, 3m, 6m, 1y maybe because it's simple. The next day, everything they traded the day before will have these "off" expiries you talk about, so pepole will build up an inventory of all sorts of expiries.
On the topic of having a huge numer of expiries in the book being difficult to manage, this is often easier to manage - it reducees 1 large pin risk to hundreds of tiny pin risks, which is much more preferable if you're not planning on offloading the risk.
