Foreign currency options
You don’t have to actually buy any currency to speculate in the foreign currency market. You can buy a foreign exchange or currency option contract. This contract gives you the right but not the obligation to buy or sell a specified amount of one currency for another at a specified price on a specified date.
Options don’t have to be exercised. The holder can decide not to exercise his or her option. If the holder decides not to exercise the option on the specified date, the option expires. This holder doesn’t have to come up with any funds on the specified date, but does lose any money spent to buy the option.
There are two types of options. A call option is the right, but not the obligation, to buy the underlying currency on a specified date. A put option is the right, but not the obligation, to sell the underlying currency on a specified date.
The person who purchases the option is the holder or buyer. The person who creates the option is the seller or writer. The price of the option is set by the seller and includes a premium that the buyer pays the seller in exchange for the right to buy or sell the underlying currency at some future date. The price at which the option is bought is called the “strike price” or “exercise price”.
The buyer of the option only risks losing the amount of money he or she paid in premium to buy the option. The writer of the option’s risk is unbounded because he or she must come up with the underlying currency if the option’s buyer decides to exercise his or her right on the specified date in the contract – even if the cost of buying or selling that underlying currency is considerably higher than when the option was originally written.
Option have been around for a long time, but only started to flourish in the foreign exchange market in the 1980s. Their popularity was aided by an international environment of floating exchange rates, deregulation, and financial innovation. Currency options started on the U.S. commodity exchanges, but are available in the over-the-counter market, too. Options are very popular, yet they make up a very small share of foreign exchange trading.