Description: This forex course basics section covers the nature of currency option transactions and the currency options market.
A currency option is a foreign exchange derivative product which gives the holder the “option” or right, but not the obligation, to buy or sell one currency against another in a forex transaction at a preset rate.
The chief feature of buying a currency option is that by holding the contract the trader or hedger can choose whether to buy or sell a currency in a specified amount, on or before a pre-determined date at a chosen rate for a known cost paid up front called the premium.
The option seller, on the other hand, receives the premium up front for agreeing to be obligated to deliver into that contract at the request of the buyer.
Forex Option Terminology
Options traders in the forex market use a number of terms that describe an option’s features. The most commonly used option related terms and their definitions can be found below:
- Call Option – Grants the right to buy a currency to the buyer.
- Put Option – Grants the right to sell a currency to the buyer.
- Delivery Date – The date in which the currencies will be exchanged in the event of the option being exercised.
- Exercise – The action performed by the holder of the option in which the seller is notified of the buyer’s intention to deliver the agreed upon currency into the option contract.
- Expiration Date – The last day that the option can be exercised by the holder for American style options, or the only day for European style options.
- Premium – The price of the option, paid up front.
- Strike Price – The agreed upon rate of exchange at which the purchase or sale of the underlying currencies takes place.
Why Trade Currency Options?
Options on currencies have become increasingly popular as tools for hedgers to manage their foreign exchange risk. For example, a U.S. company could look to purchase a Japanese Yen Put/ U.S. Dollar Call option to protect against the currency risk involved when engaged in serious negotiations to sell a subsidiary located in Japan.
Forex options can also be used as a speculative vehicle for market strategists and traders looking to cash in on short term forex moves.
Currency option trading can be done on the Chicago International Monetary Market or IMM, as well as in the Interbank forex market and with some online retail forex brokers.
Currency Option Styles
Standard currency options come in two basic styles. The first style, called the European Style option, is generally traded in the over the counter Interbank forex market and can only be exercised on the day it expires. The option also usually has a specific cut off time on that date, usually 3PM London, New York or Tokyo time.
The other option style, and the most common style for currency futures options such as those traded at Chicago’s IMM exchange, are referred to as American Style options.
The American Style option can be exercised by the holder at any time up until and including the exercise date. Because American Style options have this feature, their premiums tend to be slightly higher than their European counterparts. The added expense is sometimes known as the Ameriplus.
Despite this early exercise feature, American Style options only really make sense to exercise early if the options are deep in the money calls on the currency with the higher interest rate of the two currencies involved.