A contract that provides the right, not the obligation, to purchase or sell currencies at specified prices up to a specified expiration date.
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Last Updated: December 18, 2023 In This ArticleA currency option is a contract that provides the right, not the obligation, to purchase or sell currencies at specified prices up to a specified expiration date. This benefits the investor by hedging against any opposing movements in exchange rates.
In this case, the buyer has to pay a premium to the seller. The premium paid to the seller is the maximum amount the seller would profit off from this deal, whereas the buyer would have unlimited profit potential if things were to go their way.
This premium price could be high or low, depending on the strike price and expiration date. Once you buy an option contract, generally, you are able to re-trade or sell it.
Investors implement a wide variety of strategies using currency calls and put options in the forex market. These strategies depend on the characteristics of each involved option (e.g. expiry date, strike price, long/short).
The options exchanges in the United States are regulated by several agencies, including the Securities and Exchange Commission and the Commodity Futures Trading Commission. Options can be purchased or sold through brokers for a commission.
There is also the over-the-counter market, where currency options are offered by commercial banks and brokerage firms. Unlike the currency options traded on an exchange, the over-the-counter market offers currency options that are tailored to the specific needs of the firm.
A currency call option grants the right to buy a specific currency at a designated price within a specific period of time. The exercise price , or strike price, is the price at which the owner is allowed to buy that currency. There are also monthly expiration dates for each option.
If the spot rate rises above the strike price, the owner of a call can exercise the right to buy the currency at the strike price.
Keep in mind that the spot rate is the current exchange rate, while the strike price is the exchange rate at which the contract can be ‘exercised’.
To exercise an option, the owner simply purchases the currency at the strike price, which will be cheaper than the prevailing spot rate. This is similar to a futures contract . The only difference is the buyer of the currency option is not obligated to exercise at maturity, whereas the other is.
A call option can be:
The premium is the amount the buyer pays to the seller. Hence, it’s the cost of having the right to buy the option. Three factors affect the amount of premium a buyer has to pay:
Speculators may purchase call options in a currency they expect to appreciate or sell call options in a currency they expect to depreciate.
If they purchase call options:
Profit = Selling (spot) price - Premium price - Buying (strike) price
If they sell (write) call options:
Profit = Premium - Buying (spot) price + Selling (strike) price
A currency put option grants the right to sell a currency at a specified strike price or exercise price within a specified period of time. The owner of a put option is not obligated to exercise the option.
If the spot price falls below the strike price, the owner of a put can exercise the right to sell currency at the strike price. The maximum potential loss to the owner of the put option is the price (or premium) paid for the options contract.
The seller of a currency put option receives the premium paid by the buyer (owner). In return, the seller is obligated to accommodate the buyer in accordance with the terms of the currency put option.
A put option can be:
There are also three factors that influence currency put option premiums:
Corporations use currency put options to cover any unfavorable movements against open positions in foreign currencies.
Currency put options that are deep out of the money come at a very low price. Deep out of the money means the current exchange rate is significantly higher than the exercise price.
If they are unlikely to become profitable and get exercised because their exercise price is too low, these options would then come at a lower price, meaning a lower premium.
Consequently, as the prevailing exchange rate declines lower than the exercise price, the price of these options would rise, meaning they are more expensive, as they are more likely to be profitable and get exercised.
Individuals may speculate in the currency options market based on their expectations
of the future movements in a particular currency.
Speculators can profit from selling currency put options as well. Contrary to the buyer, who has no obligations, the seller would be obligated to purchase the specified currency at the strike price from the owner who exercises the put option.
The speculator would profit from such options based on the exercise price, at which the currency can be sold versus the spot price of the currency and the premium paid for this particular put option.
Speculators may purchase put options on a currency they expect to depreciate or sell put options on a currency they expect to appreciate.
If they purchase, put options:
Profit = Selling (strike) price - Buying (spot) price - Option premium
If they sell put options:
Profit = Option premium + Selling (spot) price - Buying (strike) price
