Trading Currency Options Over Forex Trading: Step-by-Step Guide

Mar 2, 2021 07:42 PM ET
Trading Currency Options Over Forex Trading: Step-by-Step Guide

The $6 trillion forex market is diverse, featuring a wide range of instruments that people use to profit from as currency prices fluctuate daily. While the focus is usually on forex trading, currency options are also way up as the most traded tool.

Trading Currency Options Over Forex Trading

Currency options are instruments or contracts that accord people the right to buy or sell currencies at a given price in the future. However, there is usually no obligation to buy or sell before the contract expiry date. Failure to purchase or sell before expiration triggers the premium payment.

In this case, the premium is the amount of money that one pays a seller or writer of an options contract. Given that it is a cost for holding a put or call option, it is determined by a host of factors, including overall currency value, the period from when the contract is entered to its expiry.

These financial instruments have existed forever and have always provided effective ways for hedging against wild exchange rate fluctuations. Corporation’s individuals and institutions have always used them to secure a given exchange rate, conversely averting the risk of having to pay much more when converting one currency to another.

Why currency options?

The rate at which fiat currencies are exchanged are continually fluctuating is usually of great interest to importers, exporters, and export-dependent countries. The fortunes that these people and countries stand to generate from the export market depend a great deal on the prevailing exchange rate.

To guard against wild fluctuations that could affect the preferred exchange rate, exporters and importers rely on currency options to secure a given exchange rate. These instruments make it possible to hedge against wild fluctuations.

Types of currency options

Just like other options, there are two types of currency options.

A put option is essentially a contract that accords one the right but not obligation to sell a given currency at a set price on a specific date in the future. Such instruments are triggered when people expect the prevailing exchange rate to fall significantly. If the exchange rate does not fall, then one can terminate the contract and pay the premium.

Buying Puts

The contract is mostly leveraged where one expects the value of a currency to strengthen, which could hurt one’s ability to generate more money.

On the other hand, a call option is a contract that gives people the right to buy a currency at a certain rate on a specific date in the future. If the currency rate fails to rise and meet or exceed the strike price, it becomes worthless. In this case, traders often forfeit it and end up paying the premium.

Buying calls

The instrument works best in instances where one expects a given exchange rate to weaken against another currency.

The two options can be bought through a broker. However, it is essential to note that there is usually a big difference between the European and the US currency options.

With the European options, you can only execute on the expiration date. However, the US options can be exercised at any time before expiration.

How they work

With currency options, the primary goal is to hedge against wild swings that might come into play in the future, conversely affecting currency exchange rates. In this case, people purchase put or call options based on underlying currency pairs. By essentially placing a put or call option, one secures the right to buy or sell a particular currency at a specific rate in the future.

In this case, one will be able to buy the currency at the set exchange rate regardless of the market's prevailing exchange rate. However, there is usually no obligation to complete the transaction before expiry.

Given that there is usually no obligation to complete a transaction as agreed, one only stands to pay the premium agreed on entering an option instead of completing the put or call option before expiry. However, the premium charged can be relatively high in some cases.

Example 1

Consider an Indian company that does most of its business with clients in the US. Suppose the company expects the Indian rupee to strengthen against the dollar from, say, Rs 70 to Rs 60. In that case, it may be forced to act, given that a strengthening rupee translates to a reduction of money in the company’s kitty.

If this is the likely outcome, the company may be forced to act by purchasing some currency options to secure a given exchange rate. In this case, the company would enter an option to buy no obligation to sell the rupees at Rs 70 strike price against the dollar.

Should the rupee strengthen to Rs 60 against the dollar, the company will exercise the right to sell the dollars at Rs 70. By doing so, the company will have protected itself from the strengthening of the rupee against the dollar.

In contrast, should the rupee weaken further against the dollar with the exchange rate moving to say Rs 80, the company will not exercise the right to sell Rs at 70. Instead, it will let the contract run out without doing anything and instead incur the premium cost of holding the contract. By doing so, the company will exchange the US dollar for a much higher Rs 80.

Example 2

Assume a trader is bullish on the EUR/USD pair and expects the Euro to strengthen against the dollar. The trader could simply enter a call option with, say, a strike price of $120. If the trader entered the trade when the spot price was $115, the contract would expire in money on the spot price rising past the $120 mark.

Foreign Currency Options

In this case, the trader will end up making $500 (120-115) *100. This is less the premium paid to hold the contract.

Conclusion

Currency options are contracts that accord people the right to buy currencies at specific rates and dates in the future. However, there is usually no obligation for buying or selling. They are some of the most traded instruments, given their limit or downside risk and unlimited upside potential. In most cases, they are used in hedging, whereby big corporations and engaged institutional transactions involving massive currency exchanges use them to protect themselves against wild price fluctuations.


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