A currency option is a type of foreign exchange derivative contract that confers to its holder the right, but not the obligation, to engage in a forex transaction.

In general, buying such an option will allow a trader or hedger to elect to purchase one currency against another in a specified amount by or on a specified date for an up front cost.

In terms of their trading volume, forex options currently provide roughly 5 to 10% of the total turnover seen in the foreign exchange market.

Currency Option Terminology

Rather specific jargon is used in the forex market to specify and refer to a currency option's terms. Some of the more common option related terms are defined below:

• Exercise - The act performed by the option buyer of notifying the seller that they intend to deliver on the option's underlying forex contract.

• Expiration Date - The last date upon which the option can be exercised.

• Delivery Date - The date upon when the currencies will be exchanged if the option is exercised.

• Call Option - Confers the right to buy a currency.

• Put Option - Confers the right to sell a currency.

• Premium - The up front cost involved in purchasing an option.

• Strike Price - The rate at which the currencies will be exchanged if the option is exercised.

Uses of Currency Options

Currency options have enjoyed a growing reputation as helpful tools for hedgers to manage or insure again foreign exchange risk. For example, a U.S. corporation looking to hedge against a possible influx of Pounds Sterling due to a pending sale of a U.K. subsidiary could buy a Pound Sterling put/U.S. Dollar call.

Forex options also make a useful speculative vehicle for institutional strategic traders to obtain interesting profit and loss profiles, especially when trading on medium term market views.

Even personal forex traders dealing in smaller sizes can trade currency options on futures exchanges like the Chicago IMM, as well as through some retail forex brokerages.

Some retail brokers also offer STOP or "Single Payment Option Trading" products that cost a premium, but provide a cash payoff if the market trades at the strike price. This is similar to a binary or digital exotic currency option.

Currency Option Styles and Exercise Choices

Regular currency options come in two basic styles that differ by when the holder can elect to use or "exercise" them. Such options are also often known as plain vanilla or just vanilla currency options to distinguish them from the more exotic option varieties covered in a later section of this course.

The most common style traded in the Over-the-Counter or OTC forex market is the European-Style option. This style of option can only be exercised on its expiration date up to a certain specific cutoff time, usually 3pm Tokyo, London or New York time.

Nevertheless, the most common style for options on currency futures, such as those traded on the Chicago IMM exchange, is known as American style. This style of option can be exercised at any time up to and including its expiration date.

This flexibility of American style options can add extra value to their premium relative to European style options that is sometimes called the "Ameriplus".

Nevertheless, the early exercise of American Style options usually only makes sense for deep in the money call options on the high interest rate currency, and selling the option instead will usually be the better choice in most cases.

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.