Currency options confer the right - but not the obligation - on the buyer to be able to enter into a specified underlying forex contract at a given exchange rate for a certain period of time.

This right is granted by the option's seller in exchange for an up front cost known as the option's premium.

Currency Option Pricing Factors

The price of currency options are determined by its basic specifications of strike price, expiration date, style and whether it is a call or put on which currencies. In addition, an option's value also depends on several market determined factors.

Specifically, these market driven parameters are:

• The prevailing spot rate
• Interbank deposit rates for each of the currencies
• The current implied volatility level for the expiration date

Implied Volatility in Currency Options

The implied volatility quantity is unique to option markets and is related to the annualized standard deviation of exchange rate movements expected by the market during the option's lifetime.

Option market makers estimate this key pricing factor and usually express it in percentage terms, buying options when volatility is low and selling options when volatility is high.

Currency Option Trading Example

When trading currency options, you first need to keep in mind that time really is money and that every day you own an option will probably cost you in terms of time decay. Furthermore, this time decay is larger and hence presents more of an issue with short dated options than with long dated options.

In terms of an example, consider the situation of a technical forex trader that observes a symmetrical triangle on the daily charts in USD/JPY. The triangle was also forming over several weeks, with a well defined internal wave structure that gives the trader considerable certainty that a breakout is imminent, although they are not sure in what direction it will occur.

Also, volatility - a key element affecting the pricing of currency options - in USD/JPY has declined during the consolidation period. This leaves USD/JPY currency options relatively inexpensive to purchase.

To use currency options to take advantage of this situation, the trader could simultaneously purchase a USD Call/JPY Put option with a strike price placed at the level of the triangle pattern's upper descending trend line, as well as a USD Put/JPY Call option struck at the level of the triangle's lower ascending trend line.

This way, when the breakout occurs and volatility in USD/JPY again rises, the trader can sell out the option that does not benefit from further moves in the direction of the breakout while holding the other option to benefit further from the expected measured move of the chart pattern.

Currency Option Hedging Example

In terms of a simple currency hedging strategy using options, consider the situation of a mining goods exporter in Australia that has an anticipated, although not yet certain, shipment of mining products intended to be sent for further refinement to the United States where they will be sold for U.S. Dollars.

They could purchase an Aussie Dollar call option/U.S. Dollar put option in the amount of the anticipated value of that shipment for which they would then pay a premium in advance.

Furthermore, the maturity date chosen could correspond to when the shipment was safely expected to be paid for in full and the strike price could either be at the current market or at a level for the AUD/USD exchange rate where the shipment would become unprofitable for the company.

Alternatively, to save on the cost of premium, the exporter could only buy an option out to when any uncertainty about the shipment and its destination was likely to be removed and its size was expected to become virtually assured. In this case, they could then replace the option with a forward contract to sell U.S. Dollars and buy Australian dollars in the now-known size of the deal.

In either case, when the mining producer's AUD Call/USD Put option expires or is sold, any gains achieved on it should help to offset unfavorable changes in the price of the underlying AUD/USD exchange rate.

Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.