| A currency option is a contract that gives the holder the right, but not the obligation to buy or sell a specified currency during a specific time period. It can be used to hedge a FOREX transaction and are a favored method of reducing risk in companies that trade goods overseas. |
There are two basic types of option: Call options and Put options. A call option gives the holder the right to buy a currency while a put option gives the holder the right to sell.
The worth of an option at expiry is equal to the value realized by the holder in exercising the option. If the holder gains nothing, the option is worth nothing. The value at any other time of the contract duration is the 'intrinsic value' – the value that can be realized if the holder exercises his option.
Intrinsic value is linked to the 'strike price' – the value specified by the option contract. A call option has intrinsic value if the spot (current) price is above the strike price. A put option has intrinsic value if the spot price is below the strike price.
If the option contract has intrinsic value it is said to be 'in the money', otherwise it is 'out of the money' or 'at the money' (at par). Options would only be exercised if they are in the money.
Options are priced according to complex formulas that take into consideration both the spot value and time value. Time value is calculated according to expected market conditions including volatility and the difference in interest rates between the two currencies. Options must be priced low enough to attract potential buyers and high enough to attract potential writers (the sellers or guarantors of the option).
Currency options are used in FOREX to minimize risk against unexpected moves in the market. If you buy an option your losses are limited to the cost of the option. Those who sell options are more vulnerable. They gain the premium but they are exposed to unlimited loss if the market moves against them.
As a hedging tool, there are many different types of options available. They are often used by companies that trade overseas to minimize the potential for loss due to fluctuations in the foreign exchange market.
FOREX trades have a special type of option available known as a Digital Option. This option pays a specified amount at expiration if the criteria are met, otherwise it pays nothing.
FOREX traders who wish to use a digital option first decide which direction the market is moving. They then decide on a payoff amount if the market moves as expected within a certain time frame. With this information the cost of the option is calculated.
For example:
The price of the euro is currently trading at about 1.2400 and you expect it to rise to 1.2800 within 3 months. You decide to buy a put digital option with a payoff of $5000. The cost of the option is $800.
If at the end of the 3 months the euro is more than 1.2800 you get $5000. If the price is less, you lose $800.
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