by Amanda Harvey
Currency option trading is the buying and selling of option contracts which are based on foreign exchange currency pairs. These options give the holder the right, but not the necessity, to change money from one currency to another at a specified rate either up to, or on, the date of expiration of the contract. Whether the options may be exercised during the contract or only on the date of expiration depends on the type of contract. These options are also known as forex options, and like the currency pairs they are based upon, currency options are traded on the foreign exchange market or 'forex'.
Foreign exchange trading is the world’s largest market, and as such, offers options traders a very broad and liquid market in which to trade options. Most currency option trading is conducted ‘over-the-counter’ or OTC, which means that transactions are made directly between the buyer and seller, rather than through an exchange, and as such, are not highly regulated. However, a certain amount of forex options trading happens on exchanges such as the International Securities Exchange.
How to Profit from Currency Option Trading
A trader purchases an option which entitles them to sell a certain amount of base currency for an agreed amount of the counter currency. This pre-determined exchange rate is known as the strike price. If the market rate is lower than the strike price when the trader exercises the option, this means that they can sell their base currency for more of the counter currency than its current exchange rate. They could then buy back a larger amount of their base currency with the counter currency received, immediately generating a profit of the difference minus the option premium and any fees.
Another way to profit from currency options is by selling the option contract before its expiration at a price higher than the premium paid. This method allows a trader to achieve an increase on their investment in the option without actually trading the currency upon which the option is based.
Currency Options for Hedging
Forex options can be used as insurance to help mitigate the risk of loss a forex trader may experience. An example is that a trader buys an amount of a counter currency, in the expectation that it will increase in strength compared to their base currency, and their intention is to hold the counter currency for a period of time, at which point they will buy back a larger amount of their base currency. Subsequent events then suggest that maybe the counter currency will actually weaken rather than strengthen. The trader then decides to take a currency option contract which will increase in value if the counter currency does in fact weaken, thereby offsetting the loss that would be incurred by their currency investment.
Companies involved in international trade also use currency options to hedge against fluctuations in the exchange rates which may affect their businesses.
Choosing Currency Pairs for Trading Options
Unlike stock options whose value depends on the price movement of a single stock, currency options derive their value from the comparison between two economies. This means that it is important to analyze not only the likelihood that a certain counter currency will strengthen, but how it will measure up against the base currency. If the counter currency does indeed strengthen, but the base currency strengthens even more, this will not produce a winning trade. When choosing currency pairs on which to trade options, the goal is to match a currency that is likely to weaken against one that is poised to become stronger.
Forms of both technical and fundamental analysis can be applied to trading on the forex market, but there is greater recognition of the role of fundamental analysis. In relation to currency trading, fundamental analysis studies aspects of the economy including interest and unemployment rates, trade balance, budget and GDP (Gross Domestic Product).
For traders wishing to trade options, currency option trading provides a wide spectrum of opportunity, however there are factors which can make it more complicated than trading stock options. Currency options can offer the chance to profit as the currencies of two economies fluctuate in relation to each other. This profit can be attained through trading the actual currencies, or by simply trading the options. These option contracts are also an effective hedging tool for those affected by potentially unstable exchange rates.