Currency Options

Currency options are derivatives contracts in which foreign currency is the underlying asset. Currency options are also known as forex options or Fx options. The contract is between a buyer and a seller and gives the buyer the right (but not the obligation) to buy or sell the underlying foreign currency at a specified price on an agreed upon date in the future.

Currency options are of two types: call options and put options. The buyer of a call option has the right to buy the underlying currency at an agreed upon price at a future date. A put option provides the buyer the right to sell the underlying currency.

How are Currency Options Traded?

While currency options give the buyer the right to buy or sell the underlying currency, there is no obligation to do so. However, the seller of the currency options is obligated to buy or sell the underlying currency in case the buyer decides to exercise the option.

For exercising the right to trade the underlying asset, the seller of the option is paid a price, known as premium. The price that is specified for either buying or selling at the future date is known as the strike price.

When an investor believes that the US dollar will appreciate against the Euro, he purchases a currency call option on USD/EUR. If the value of the US dollar actually increases against the Euro, the buyer can exercise his right to earn a profit.

Benefits of Currency Options

The benefits of currency options are:

Currency options are extremely useful for hedging against the adverse movements of exchange rates.

Currency options are the only option contracts that are traded 24 hours a day.

Risks of Currency Options

The risks associated with currency options are:

Currency options change in value very frequently, since they are tied to the volatile forex market.

The small outlay that is paid as the initial margin may prevent an investor from estimating the actual losses that he may suffer due to adverse market conditions

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