Currency options are contracts between a buyer and a seller that gives the buyer the right, but not the obligation, to trade a specific amount of currency at a predetermined price and within a predetermined period of time (regardless of the market price of the currency) and gives the seller (writer) the obligation to deliver the currency under the predetermined terms, if and when the buyer wants to exercise the option.
Currency options are unique trading instruments, equally fit for speculation and hedging. They allow for a comprehensive customization of each individual strategy, a quality of vital importance for the sophisticated investor. More factors affect the option price relative to the prices of other foreign currency instruments. Unlike spot or forwards, both high and low volatility may generate a profit in the options market. For some people, they are a cheaper vehicle for currency trading. For other people, they mean added security and exact stop-loss order execution.
Here are some of their characteristics:
- Constitute the fastest-growing segment of the foreign exchange market.
- The biggest trading center is the United States, followed by the United Kingdom and Japan.
- Prices are based on, or derived from, the cash instruments. Therefore, an option is a derivative instrument.
- In the currency markets, they are available on either cash or futures. It follows, then, that they are traded either over-the-counter (OTC) or on the centralized futures markets.
- Around 81% are traded over-the-counter. The over-the-counter market is similar to the spot or swap market.
- Corporations may call banks and banks will trade with each other either directly or in the brokers' market. This type of dealing allows for maximum flexibility: any amount, any currency, any odd expiration date, and any time. The currency amounts may be even or odd. The amounts may be quoted in either U.S. dollars or foreign currencies.
- Any currency may be traded as an option, not only the ones available as futures contracts. This way, traders may quote on any exotic currency, as required, including any cross currencies.
- The expiration date may be quoted anywhere from several hours to several years, although the bulk of dates are concentrated around the even dates (one week, one month, two months, and so on). The cash market never closes, so options may be traded literally around the clock.
Trading an option on currency futures will entitle the buyer to the right, but not the obligation, to take physical possession of the currency future. Unlike the currency futures, buying currency options does not require an initiation margin. The option premium (price) paid by the buyer to the seller (writer) reflects the buyer's total risk. However, upon taking physical possession of the currency future by exercising the option, a trader will have to deposit a margin.
Seven major factors have an impact on the option price:
- Price of the currency
- Strike (exercise) price
- Volatility of the currency
- Expiration date
- Interest rate differential
- Call or put
- American or European option style
The currency price is the central building block, as all the other factors are compared and analyzed against it. It is the currency price behavior that both generates the need for options and has an impact on their profitability.
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