Within the Forex market it is common for traders to use currency options in order to minimize their trading risk. A currency option is simply a contract which gives the holder of the option the right, but not the obligation, to buy or sell a specified currency within a prescribed timeframe. Currency options are also widely used outside of the Forex markets and are particularly favored by companies trading in goods overseas.
Currency options are purchased as either call options or put options. A call option gives the purchaser the right to buy a particular currency, while a put option gives the purchaser the right to sell a specified currency.
The value of an option at its expiry date is equal to the value realized by the holder in exercising his option. If, for example, the purchaser gains nothing, the option is worth nothing. The value at any other time during the timeframe of the contract is said to be its "intrinsic" value and this is the value that can be realized if the purchaser decides to exercise his option.
The intrinsic value of a currency option is linked to what is known as the "strike price" which is the currency price specified in the option contract. A call option (the right to buy) has intrinsic value if the spot, or current, price is above the strike price. A put option (the right to sell) has intrinsic value if the spot price is below the strike price.
If the option contract has intrinsic value it is said to be "in the money", otherwise it is said to be "out of the money". When the strike and spot prices are equal then the contract is referred to an being "at the money" or "at par". Clearly a purchaser would only elect to exercise his option when it is in the money.
The pricing of options is a complex business and takes into account many different factors including both the spot value and time value. The latter is calculated from an expectation of future market conditions and such factors as the difference in interest rates between the currencies in question and the volatility of the market. The important point here is that options must be priced low enough to attract buyers but also high enough to attract writers (those selling and standing as guarantors on options).
In the Forex market currency options are used to offset the risks of unexpected movements in the market and effectively limit a trader's losses to the cost of purchasing the option. The seller of course takes a higher risk as, although he gains a premium on the sale, he also runs the risk of a virtually unlimited risk if the market moves against him.
Forex trades attract a particular form of option known as a "digital option". This form of option pays a specific sum of money at expiry if certain conditions are met. If these conditions are not met then the option pays nothing at all.
For the Forex trader it is simply a question of deciding in which direction the market is likely to move and then deciding upon a payoff should the market move as he expects within a given timeframe.
As an example of a digital option in action let's assume that the Euro is trading today at 1.6700 and that the trader expects that within three months it will be trading at 1.7300 and that he wishes to purchase a digital option. He looks around and decides to buy an option with a payoff of $7,000 at a purchase price of $1,200. If at the end of three months the Euro is trading above his predicted price of 1.7300 then he will receive $5,000. However, if the Euro is trading below 1.7300 he will receive nothing and will have effectively lost his original purchase price of $1,200.
By Donald Sounders
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