What Is a Currency Option?
A currency option (also known as a forex option) is a contract that gives the buyer the right, but not the obligation, to buy or sell a particular currency at a specified exchange rate on or before a specified date. For this right, a premium is paid to the seller.
Currency options are one of the most common ways for corporations, individuals, or financial institutions to hedge against adverse movements in exchange rates.
The Basics of Currency Options
Call options allow the holder to buy a currency pair at a stated price within a specific timeframe. Put options will enable the holder to sell a currency pair at a stated price within a particular timeframe.
There are a few critical components in a foreign currency option.
- The Premium is the option buyer's price for the right to buy or sell that currency at a fixed rate on or before a specific expiration date.
- The Strike Price is the exchange rate at which the currency will be bought or sold before that maturity date.
A Japanese company with USD/JPY exposure could buy a currency option with an expiration date set for six months later to protect itself against any adverse currency movements if they have a USD payment due on that date.
If the strike price is more favorable than the spot exchange rate on the date on which this option matures, the option expires “in the money” (“ITM”), and the holder should exercise it.
However, if the exchange rate on the expiration date is better than the strike price, the holder will not exercise his option. In this scenario, the option expires “out of the money” (“OTM”).
While currency options are one of the hedging instruments available to businesses, they are mainly used for speculation in practice.
Currency traders use options to make money by purchasing the option and exchanging that cash on the spot market to pocket the difference.