Currency options are used by traders in forex transactions whereby the owner of the currency option has the right to trade it. Options are sold for a price paid upfront and allow the buyer to trade one currency against another. Because forex currency options make up 5–10% of the turnover in the forex trading market, it’s essential to have a broad understanding of this concept. Firstly, you’ll need to know the following terminology to get through the basics and develop systematic strategies.
The pricing of currency options
The strike price, expiration date and whether it’s a call or put all contribute to the pricing. The market also influences the pricing, such as the spot rate, the deposit rate, and the volatility of the expiration date. This implied volatility is determined by the changing exchange rate’s estimate each year and is unique to each market. The general trend is to buy when volatility is low and sell when volatility is high.
Trading in currency options
When trading with currency options, it is vital to keep in mind that time is of the essence, specifically because of expiration dates. An example of trading in currency options is a trader who is looking into an inexpensive USD /JPY currency option. In order to make the best of this option, the trader can purchase a USD Call / JPY Put option at a descending strike level, and a USD Put / JPY Call option at an ascending strike level. Therefore, when the volatility rises, the trader can sell the option that they will not benefit from, and keep the one that will be beneficial.
Currency option uses
Although many traders love forex trading, forex poses various risks and trading in currency options has come to be known as a helpful tool with which to manage hedges. For example, an Australian exporter of mining goods might have a shipment intended for further refining in the US, which will then be sold in US dollars. The exporter could buy an AUD Call / USD Put option for the expected value of the shipment. The expiration date could coincide with the expected date of the shipment’s delivery date, with a strike price similar to the current market value.
The exporter could also buy an option out until the details of the shipment have been confirmed. Once this is done, the exporter can then replace the original option with a contract to buy AUD and sell USD with more accuracy. This way, any changes in the exchange rate will be taken care of when the option expires or is sold.
Option styles and choices
There are two basic styles that form part of our forex trading advice for currency options. The first style is the Over-The-Counter (OTC) market that uses the European style, whereby the option can only be exercised on its expiry date by a certain cut-off time. The second style is used on the Chicago IMM market and is the American style. This style allows for the option to be exercised at any time before and on its expiry date, affording more flexibility and a greater value on the premium. The American style call option is used mostly for high interest rates, while the selling option is more popular in most cases.