What are Currency Options?

In finance, currency options are financial instruments which give their owner the right, but not the obligation, to exchange money from one currency to another at an agreed-upon exchange rate on a certain date. The broker is paid a premium for this right, which can vary. The premium depends on the number of contracts purchased. Currency options are an excellent way for corporations and individuals to hedge against unexpected movements in exchange rates. Currency options are also called foreign exchange options.

Someone who invests in foreign currencies can hedge his risk by buying a currency option in the form of a put or call. For example, if an investor believes that the U.S. Dollar will become more expensive in terms of the European Euro, he would buy a call option in an attempt to profit from the rise in the relative value of the Dollar. If, on the other hand, he thinks that the U.S. Dollar will become cheaper in terms of Euros, he would be wise to buy a put option, which would allow him to profit from the decrease in the exchange rate.

Most of the currency options in the world are traded over the counter (OTC). OTC options contracts, whether they are currency options or another type, are not traded on exchanges, but rather between two private parties. As such, these markets are not subject to the same degree of regulation that stock exchanges are. It is usual that at least one of the parties in a transaction of currency options is a large institution that is well-capitalized.

By avoiding the use of an exchange, buyers and sellers of currency options can tailor them to their exact needs. This provides a significant advantage to those looking to hedge risk in these markets. The lack of outside regulation does not necessarily mean that there is more risk inherent in the transaction, since most parties who buy and sell options OTC must have open credit lines with each other, and agree upon procedures for clearing and settling transactions.

The market in currency options has the distinction of being the options market with the most volume and liquidity of all. American-style options are slightly different from European-style options, in that American options can be exercised on any day up to and including the date that the contract expires, while European options can only be exercised on one specific day. In trading these options, one must keep in mind which type of option he is trading, and which will provide him the most benefit.