A currency option is a pretty simple thing. It is just 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 favoured method of reducing risk in companies that trade goods
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 one of these options at expiry is equal to the value realised 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
which can be realized if the holder exercises his option.
Intrinsic value is linked to the "strike price", i.e. 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
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", or at
par. Options will rationally only be exercised if they are in the money.
Options are priced according to some fairly 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
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.