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Century Financial Consultancy

Trading FX options

One of the most common reasons for using FX options is for short-term hedges of spot FX or foreign stock market positions. Learn more.

An FX option (foreign exchange option or currency option) is a financial derivative that gives the right, but not the obligation, to buy or sell a currency pair at a set price (called the strike price) on a specified date (called the expiry date).

Options contracts are similar to both futures and forwards trading, although once these contracts have been put together, you are obligated to carry out their full duration. A call option gives you the right to buy, a put option gives you the right to sell.

FX options are, for the most part, fundamentally driven by the same factors that drive the underlying currency pairs, such as interest rates, inflation expectations, geopolitics and macroeconomic data such as unemployment, GDP, consumer and business confidence surveys.

There are two styles of options: European and American. The European-style option can only be exercised on the expiry date. The American-style option can be exercised at the strike price, any time before the expiry date.

How are FX options traded?

FX option traders can use the 'Greeks' (Delta, Gamma, Theta, Rhio and Vega) to judge the risks and rewards of the options price, in the same way as you would equity options.

The risk for an option buyer is limited to the cost of buying the option, called the 'premium'. An option buyer has theoretically unlimited profit potential. Conversely, for an option seller the risk is potentially unlimited, but the profit is fixed at the premium received.

Access to FX options

FX option contracts are typically traded through the over-the-counter (OTC) market so are fully customizable and can expire at any time. In the spot options market, when you buy a 'call', you also buy a 'put' simultaneously. For example, a trader might buy an option for the right to purchase one lot of EUR/USD at 1.00 (or parity) in three months. This is a 'EUR call/USD put'.

FX options are also available through regulated exchanges which are options on FX futures, in which case it is simply a call or a put. These offer a multitude of expirations and quoting options with standardized maturities. When traded on an exchange, FX options are typically available in ten currency pairs, all involving the US dollar, and are cash settled in dollars.

Why trade FX options?

One of the most common reasons for using FX options is for short-term hedges of spot FX or foreign stock market positions. For example, if you were buying EUR/USD but you thought there might be a short-term decline in the price, you could also buy a euro put option to profit from the decline while maintaining your buy. You could also sell EUR/USD short at the same time as buying.

There are many bullish, bearish, and even neutral strategies that can be implemented with options contracts.

An FX option can either be bought or sold. Options prices are derived from the base currency, which is the first currency in the currency pair (eg euros in EUR/USD). If you are bullish on the base currency then you should buy calls or sell puts, conversely if you are bearish you should buy puts or sell calls.

Source: CMC Markets UK

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