An introduction to Currency Options

• A currency option refers to a derivative contract that gives the buyer the right but
not the obligation to sell or buy currencies at a specified exchange rate within a
specified time frame. They are useful for investors to hedge against unfavorable
movements in exchange rates.
• In this case, the buyer has to pay a premium to the seller. The premium paid to the
seller is the maximum amount the seller would profit off from this deal, whereas
the buyer would have unlimited profit potential if things were to go their way.
• This premium price could be high or low, depending on the
strike price and expiration date. Once you buy an option contract, generally, you
are able to re-trade or sell it.
 An introduction to Currency Options
• Investors implement a wide variety of strategies using currency
calls and put options in the forex market. These strategies depend on the
characteristics of each involved option (e.g. expiry date, strike price,
long/short).
• The options exchanges in the United States are regulated by several agencies,
including the Securities and Exchange Commission and the Commodity
Futures Trading Commission. Options can be purchased or sold through
brokers for a commission.
• There is also the over-the-counter market, where currency options are offered
by commercial banks and brokerage firms. Unlike the currency options traded
on an exchange, the over-the-counter market offers currency options that are
tailored to the specific needs of the firm.
 An introduction to Currency Options
• Currency options, often referred to as forex options, are financial
contracts that give traders the right—but not the obligation—to buy or sell
a specific currency pair at a predetermined price, before or on a specified
expiration date. These options allow traders to hedge against potential
currency fluctuations or to speculate on currency movements. Unlike
futures contracts, which are obligations, options provide more flexibility
in decision-making, making them valuable tools in the forex market.
• Currency options are widely used by businesses, institutional investors,
and individual traders to manage currency risk. They are a common
feature in global trading and provide a strategic way to mitigate foreign
exchange risk or profit from favorable exchange rate movements.
 Currency Option Terminology
Rather specific jargon is used in the forex market to specify and refer to a
currency option’s terms. Some of the more common option related terms are
defined below:
• Exercise – The act performed by the option buyer of notifying the seller
that they intend to deliver on the option’s underlying forex contract.
• Expiration Date – The last date upon which the option can be exercised.
• Delivery Date – The date upon when the currencies will be exchanged if
the option is exercised.
• Call Option – Confers the right to buy a currency.
• Put Option – Confers the right to sell a currency.
• Premium – The up front cost involved in purchasing an option.
• Strike Price – The rate at which the currencies will be exchanged if the
option is exercised.
 What Are Call Options?
• A currency call option grants the right to buy a specific currency at a designated price within a
specific period of time. The exercise price, or strike price, is the price at which the owner is
allowed to buy that currency. There are also monthly expiration dates for each option.
• If the spot rate rises above the strike price, the owner of a call can exercise the right to buy the
currency at the strike price.
• Keep in mind that the spot rate is the current exchange rate, while the strike price is the
exchange rate at which the contract can be ‘exercised’.
• To exercise an option, the owner simply purchases the currency at the strike price, which will
be cheaper than the prevailing spot rate. This is similar to a futures contract. The only
difference is the buyer of the currency option is not obligated to exercise at maturity, whereas
the other is.
A call option can be:
• In the money → If the exchange rate > strike price
• At the money → If the exchange rate = strike price
• Out of the money → If the exchange rate < strike price
 Factors that affect currency call option
premiums
The premium is the amount the buyer pays to the seller. Hence, it’s the cost
of having the right to buy the option. Three factors affect the amount of
premium a buyer has to pay:
1.Spot price relative to the strike price: The higher the spot price relative
to the strike price, the higher the option’s price will be.
2.Length of the time before expiration: The longer the time to expiration,
the higher the option price will be. This is because there is more time for
a spot rate to move above the strike price.
3.Potential variability of a currency: The greater the variability of the
currency, the higher the probability that the spot rate can rise above the
strike price.
Firms can use call options to:
• Hedge future payables
• Hedge project bidding to lock in the dollar cost of potential expenses
• Hedge target bidding of a possible acquisition
• Speculate on expectations of future movements in a currency.
Speculators may purchase call options in a currency they expect to appreciate or sell
call options in a currency they expect to depreciate.
If they purchase call options:
• Profit = Selling (spot) price - Premium price - Buying (strike) price
If they sell (write) call options:
• Profit = Premium - Buying (spot) price + Selling (strike) price
 What are Put Options?
A currency put option grants the right to sell a currency at a specified strike price
or exercise price within a specified period of time. The owner of a put option is
not obligated to exercise the option.
If the spot price falls below the strike price, the owner of a put can exercise the
right to sell currency at the strike price. The maximum potential loss to the owner
of the put option is the price (or premium) paid for the options contract.
The seller of a currency put option receives the premium paid by the buyer
(owner). In return, the seller is obligated to accommodate the buyer in accordance
with the terms of the currency put option.
A put option can be:
• In the money → If the exchange rate < strike price
• At the money → If the exchange rate = strike price
• Out of the money → If the exchange rate > strike price
 Factors that affect currency put option
premiums
There are also three factors that influence currency put option premiums:
1.Spot price relative to strike price: The lower the spot rate relative to the strike price,
the more valuable an option is, and the higher the premium.
2.Length of time until expiration: The longer the time to expiration, the greater the put
option premium.
3.Variability of the currency: The greater the variability, the greater the probability that
the option will make significant moves, possibly moving the option closer/further in the
money. This makes the option more valuable.
Corporations use currency put options to cover any unfavorable movements against open
positions in foreign currencies.
Currency put options that are deep out of the money come at a very low price. Deep out of
the money means the current exchange rate is significantly higher than the exercise price.
If they are unlikely to become profitable and get exercised because their exercise price is
too low, these options would then come at a lower price, meaning a lower premium.
• Consequently, as the prevailing exchange rate declines lower than the exercise price,
the price of these options would rise, meaning they are more expensive, as they are
more likely to be profitable and get exercised.
• Individuals may speculate in the currency options market based on their expectations
of the future movements in a particular currency.
• Speculators can profit from selling currency put options as well. Contrary to the
buyer, who has no obligations, the seller would be obligated to purchase the specified
currency at the strike price from the owner who exercises the put option.
• The speculator would profit from such options based on the exercise price, at which
the currency can be sold versus the spot price of the currency and the premium paid
for this particular put option.
• Speculators may purchase put options on a currency they expect to depreciate or sell
put options on a currency they expect to appreciate.
If they purchase, put options:
• Profit = Selling (strike) price - Buying (spot) price - Option premium
If they sell put options:
• Profit = Option premium + Selling (spot) price - Buying (strike) price
 Examples of a Currency Option
Suppose the following:
• An individual buys a British pound call option with a strike price of $1.50
• The current spot rate at the date that he bought the call option is $1.48
• The premium to pay for that British pound call option is $0.01$
• Just before the expiration date, the spot rate of the British pound reaches
$1.52
Since the spot rate, the current exchange rate, is higher than the strike price at
which this individual bought the option, they should exercise the call option.
Once exercising, the individual can sell the pounds at the spot rate.
 Assuming one option contract specifies 20,000 units, to calculate the
individual’s profit:
• Profit = Selling price (strike rate) - Purchase price (spot price) - Option
premium
• Profit = ($1.52 x 20,000) - ($1.50 x 20,000) - ($0.01 x 20,000)
• Profit = $30,400 - $30,000 - $200
• Profit = $200
The profit for the person on the other end of this deal, the seller of the call
option, can be calculated using the following formula:
• Profit = Selling (spot) price - Purchase (strike) price + Option premium
• Profit = ($1.50 x 20,000) - ($1.52 x 20,000) + ($0.01 x 20,000)
• Profit = $30,000 - $30,400 + $200
• Profit = -200$
 Currency Put Option example
Suppose the following:
• An individual buys a British pound call option with a strike price of
$1.30
• The premium to pay for that British pound call option is $0.03
• Just before the expiration date, the spot rate of the British pound
reaches $1.25
• Since the spot rate, the current exchange rate, is lower than the strike
price, they should exercise the call option
• Once exercising, the individual can sell the pounds at the spot rate.
 Assuming one option contract specifies 10,000 units, to calculate the
individual’s profit:
• Profit = Selling price (strike price) - Purchase price (spot rate) - Option premium
• Profit = ($1.30 x 10,000) - ($1.25 x 10,000) - ($0.03 x 10,000)
• Profit = $13,000 - $12,500 - $300
• Profit = $200

To deal with the person on the other end (selling the put option), their profit
would be:
• Profit = Selling price (spot price) - Purchase price (strike price) + Option
premium
• Profit = ($1.25 x 10,000) - ($1.30 x 10,000) + ($0.03 x 10,000)
• Profit = $12,500 - $13,000 + $300
• Profit = -$200
 Using options: Arbitrage
• Arbitrage is taking advantage of pricing differences of the same asset, but in a different
market. In essence, arbitrage is a situation where a trader can profit from the imbalance
of asset prices in different markets. The simplest form of arbitrage is purchasing an
asset in the market where the price is lower and selling the asset in the market where
the asset’s price is higher.
• Warren Buffet, as a child used to buy a pack of 6 Coca-Cola’s bottles for 20 Cents and
used to sell each bottle for 5 Cents to people in his neighborhood, earning 30 Cents in
total for a pack and profiting 10 Cents per pack. Young Buffet saw the arbitrage
opportunity that he could profit from. The difference in price of a pack against the
price of an individual bottle that people were willing to pay.
• The most popular form of arbitrage is spot-to-futures trade, which is used across asset
classes and markets. The most proven age-old arbitrage is taking advantage of mis-
pricing in stocks between NSE and BSE, however, with deployment of algorithms
these arbitrage opportunities are almost nonexistent for retail investors without access
to algorithms.
 Option arbitrage
• This refers to buying and selling of options to take advantage of mis-pricing in
premium or price of options. This kind of trades carry very low to zero risk and
profit potential is also on the lower side.
• Arbitrage opportunities in options arise on two fronts. Option arbitrage can either
be initiated between two options or between options and an underlying asset. The
former is based on the principle of put-call parity and the latter is based on
divergence of intrinsic value and moneyness of options.
• Put-call parity is an important concept that shows the prices of put, call and
underlying asset must be consistent with one another. The put-call parity
relationship shows that a portfolio consisting of long call option and short put
option (Long synthetic futures position) would be equal to the short future contract
with the same underlying asset, expiration and strike price. This can be explained
using simplified equation.
 Arbitrage example
• The arbitrage strategy is very simple yet very clever. It involves
buying a product and selling it immediately in another market for a
higher price; thus, making small but steady profits. The strategy is
most commonly used in the stock market.
• Let’s take a very simple example of a junior high school student
buying a pair of Asics shoes from the outlet store that is near his home
for only $45 and selling it to his schoolmate for $70. The schoolmate
is happy to find a much cheaper price compared to the department
store which sells it for $110.
 Using options: Hedging
• Hedging is a financial strategy that should be understood and used by investors because
of the advantages it offers. As an investment, it protects an individual’s finances from
being exposed to a risky situation that may lead to loss of value. However, hedging
doesn’t necessarily mean that the investments won’t lose value at all. Rather, in the event
that happens, the losses will be mitigated by gains in another investment.
• Hedging is recognizing the dangers that come with every investment and choosing to be
protected from any untoward event that can impact one’s finances. One clear example of
this is getting car insurance. In the event of a car accident, the insurance policy will
shoulder at least part of the repair costs.
• Hedging with options involves opening a position – or multiple positions – that will
offset risk to an existing trade. This could be an existing options position, another
derivative trade or an investment.
• While hedging strategies can’t entirely remove all your risk – as creating a complete net-
zero effect is nearly impossible – they can limit your risk to a known amount. The theory
of hedging is that while one position declines in value, the other position (or positions)
would make a profit – creating a net zero effect, or even a net profit.
How Do Hedging Strategies Work?
• Hedging is the balance that supports any type of investment. A common form of
hedging is a derivative or a contract whose value is measured by an underlying
asset. Say, for instance, an investor buys stocks of a company hoping that the
price for such stocks will rise. However, on the contrary, the price plummets and
leaves the investor with a loss.
• Such incidents can be mitigated if the investor uses an option to ensure that the
impact of such a negative event will be balanced off.
• An option is an agreement that lets the investor buy or sell a stock at an agreed
price within a specific period of time. In this case, a put option would enable the
investor to make a profit from the stock’s decline in price. That profit would
offset at least part of his loss from buying the stock. This is considered one of
the most effective hedging strategies.
 What is speculation?
• Speculation in financial terms is defined by Oxford Languages as “investment in stocks,
property, or other ventures in the hope of gain but with the risk of loss”. Options are a
financial tool that can be used to facilitate an investor’s belief that a security will rise or
fall. In simplest terms a trader who believes a security’s price will rise may purchase a call
or sell a put. Conversely, if they believe the security will fall then they may want to sell a
call or purchase a put.
• Options allow the investor to play a directional movement while outlaying less premium
than trading the security itself. Of course, speculative trading has a substantial risk of
losing but also can produce more than enough substantial gain to offset the risk of loss if
the trade becomes profitable. Speculators generally focus on shorter term price movements
and are willing to take on risks to generate profit whereas investments are generally
longer-term commitments to price movement.
• Speculation is the opposite where investors use options to take on risk, and potentially
enough profit to offset the risk.