A foreign exchange option, also known as an FX option or a currency option, is a contract that grants the buyer the right, but not the obligation, to buy or sell currency at a specified exchange rate on or before an expiration date.
Currency options give corporations, financial institutions, and individuals the opportunity to limit risk and increase profit in the foreign exchange market. This article will give investors a basic understanding of FX options so that they can be used in personal investing portfolios.
There are two types of currency options. The more commonly used type is the traditional call and put option, which works similarly to a stock option. The other type is called “single payment option trading,” or SPOT.
When using the traditional currency options, a call gives the buyer of the option the right to purchase a currency pair at a specified exchange rate at a set time in the future. A put gives the buyer of the option the right to sell a currency pair at a specified exchange rate at a set time in the future. If the options are “out-of-the-money” at expiration, then the options expire worthless. If the options are “in-the-money” at expiration, then the options can be exercised.
In traditional currency options, there is the American-style and European-style options. In the American-style options, the option can be exercised at any point up until expiration or on expiration. In European-style options, the option can be exercised only on the date of expiration.
Forex options are traded over-the-counter on exchanges where buyers pay a premium to the sellers for the option rights. Generally, traditional currency options are cheaper than SPOT options.
A SPOT option allows an investor to set the conditions that need to be met in order to receive a desired payout but also the size of the payout he wishes to receive if the conditions are met. Therefore, SPOT options are easier to set and execute than traditional options.
For example, an investor would buy a SPOT option by inputting a desired scenario such as, “I expect EUR/USD to have an exchange rate above 1.5000 10 days from now.” From this, a premium would be quoted. If the investor pays the premium and purchases the option, then the SPOT will automatically pay out should the scenario occur.
Traditional currency options and SPOT options are good tools to earn a profit or hedge against loss in the foreign exchange market. From this article, investors should have a basic understanding of both types of FX options.