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. To learn more about forex trading, visit forex for dummies here.
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. This right is granted by the option’s seller in exchange for an up front cost known as the option’s premium.
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.
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.
Uses of Currency Options
Currency options have enjoyed a growing reputation as helpful tools for hedgers to manage or insure against 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.
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.
More uses of currency options
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.