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Home  >  About Forex  >  Derivatives  >  Currency options


Currency options



What is commonly known as a Forex option is a contract which allows a person the right to buy or sell an item of their choosing at a given price for a limited period of time, however is does not oblige them to do so. The only person obliged to perform anything is the seller of the option.

In other words, the person who is buying a currency option retains the option, without being obliged, to buy (known as a "call") or sell (known as a put) any amount of a given currency for a different currency at a negotiated price and date. The buyer is always responsible for paying the cost of buying the option, known as a 'premium' to the seller. The price of the premium is determined by the seller and is commonly based on nominated delivery, current rates, the determined strike rate, expiry dates, and option style.

The seller gives his terms and then it is the buyers decision as to whether or not to go through with a deal; If a buyer does accept then the seller is clearly obliged to follow through with the deal.

Call option

A Call Option is the option one has to BUY any given asset (currency or stock) at a mutually determined price (called the Strike Price or Exercise Price) on or sometime before the expiration date passes. Due to the fact that this option has potential economic value, the buyer must pay a price, known as the Premium.

Put option

A Put Option gives the owner of an asset the option to sell an asset at a stated price on or before the expiration date passes without obliging him to do so.

The option is available to be put to use until the expiration date at which point it expires. An important term to be familiar with is the exercise price or strike price which is the rate at which a currency can be purchased or sold. A full depiction of a currency option should include the currencies involved, the size of the contract, the expiration date, the exercise price and one final detail which should not be forgotten: Whether the option is one to buy the currency in question - known as a call - or an option to sell the currency in question- known as a put.

A Currency Option is a binding contract that exists between two parties thus it is each parties responsibility to be aware of the other parties credit standing and capacity before striking a deal.

There are two different types of option expirations -European-style and American-style . European-style options can be exercised only on the expiration day whereas American-style options are available to be exercised any given business day prior to the expiration date.

In summery, currency options permit the holder of an asset the right to buy or sell a certain amount of foreign currency at an agreed upon price without the actual obligation to do so. American options may be executed on any business day prior to the expiration date, while 'European' options are only executable on the expiration date. The majority of currency options utilize 'American' exercise features. The right of the holder to buy foreign currency is known as call options, the right of the holder to sell foreign currency is known as put options.

Call options are profitable when the exchange rate of the bought currency rises above the exercise price (allowing the holder to sell foreign currency at a higher rate). While put options are profitable once the exchange rate of the sold currency falls below the exercise price (allowing the holder to buy foreign currency at a lower rate). In the event that the exchange rate fails to reach a specific level in which the holder of the option can make a profit prior to its expiration date, it becomes worthless. Dissimilarly to futures and forwards, the holder of the option takes zero obligation to buy or sell if it is disadvantageous for him to do so.

Other varieties of currency options:

Average Rate Option

An average rate option is determined by comparing the average of the spot rate over the option period with the strike. This is very much unlike a conventional option, which is determined by comparing the spot rate at the expiration with the strike. This action is valuable because it hedges against price shifts without fixing in a locked rate or price upfront. The average rate option can be arithmetic or geometric and can commence during any point in the option period. Both the interval of underlying price observations as well as the sampling process frequency can be specified to the user's specific requests.

Dissimilar to a straight European or America-style option, an average rate option can be determined more than one time over its life course. For example, someone who holds a one-year average rate option is able to decide each month whether to settle the option and can do so advantageously by comparing the average price or rate to what is was the previous month. Average rate options are generally less expensive than conventional options because the averaging process flattens the underlying price fluctuations thereby decreasing its volatility and thus additionally the premium of the option. The volatility of an average rate option usually tends to be about half the volatility of a conventional option. The average rate option is also called the Average Price or Asian option. Due to this the practice of averaging has become applicable to a wide variety of options and swaps.

Average Strike Option

An Average strike option is nearly exactly the same as a standard option with the only difference being that the strike price is the average price of the underlying asset during the options continued life.

Originally currency options were traded by OTC (dealer networks), not on organized exchanges. Currency traders consisted of intl. banks, brokerage houses and investment banks.

Options in OTC can be customized specifically to meet the needs of the traders in all aspects including contract size, maturity, exercise price, most of the time in large amounts of millions of dollars, and the size of most currency trades in the spot market.

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