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What are currency (FX) options, and how to use them?

timTim Clayton is a market analyst with more than 20 years of experience in the financial markets, with particular focus on currencies. Holds an economics degree from University of New York. Writes for multiple publications including Investing.com and SeekingAlpha so he is on top of all the happening in the world of currencies and macro-economics.

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Note: all graphs are taken from TradingView – https://www.tradingview.com/
Options are a contract between two parties which give the buyer right, but no obligation, to buy or sell a currency pair at a fixed price and date.

Options are an important tool in minimising exposure to risk or in other words – hedging. There is also scope for using options as a leveraged instrument to make speculative gains while minimising the extent of losses.

Buying and selling options

Call options are a contract to have the option to buy a currency pair at a particular level. Put options are a contract to have the option to sell a currency pair at a particular level.

There are two sides to the option market as there needs to be a seller on the other side of any contract. Buyers pay a premium which is received by the option writer (seller). If the option expires as worthless, the writer will keep the premium, but will have to make a substantial pay-out if the option is exercised.

Individuals are likely to focus on buying options rather than writing contracts given the risks involved.

There is substantial leverage involved in options with sharp moves in prices in the underlying instrument change. In this context, there is a clear risk of over-trading and clear strategies are required.

How to access FX options

The easiest and most common way to trade FX options is through currency brokers. Some of the large reputable brokers will offer the facility to trade options, especially money transfer companies that have a specialised business FX department. Trading options will require a different licensing than the license most FX companies hold.

Another common way to buy and sell options is through investment firms or stock brokers. You will need to have a margin account, and if you intend to write any options, you will have to deposit funds as security.

Very large customers may be able to trade directly on exchanges, although this is unlikely to be an option for retail or smaller corporate customers.

It is important to note that these options are traded over the counter and not through a regulated exchange. There is, therefore, the potential for different pricing across providers, although arbitrage opportunities should help narrow significant differences.Options are easily available for all the major currency pairs.There will be difficulties for more exotic currencies and options will be more expensive in the exotic pairs. In these circumstances alternative instruments such as forwards are likely to be preferable for corporate hedging.

Types of options

Vanilla or European options are the most basic form of option and can only be exercised at the expiry date. These options are cheaper and have some value when looking to hedge commercial exposures. In contrast, American options can be exercised at any point during the contract. These options are likely to be much more suitable for speculative trades given the ability to close out a contract early. More complicated options are available such as touch and no-touch contracts.

Option pricing

Options are priced by formulas using the Black-Scholes model.

The variables used to determine the cost of an individual option are as follows:

  • Strike price
  • Interest rates for both underlying instruments
  • The time to the maturity date
  • Underlying volatility in the exchange rate

The time to maturity is important and it will be more expensive to buy an option further into the future given that there is more time for the underlying asset to change in value.Volatility is an important component as it is more expensive to buy an option when volatility is high given a higher structural risk that any particular price will be hit.

Out of the money options.

Choosing the correct strike price is extremely important for cost and potential to make gains. It will be much cheaper to buy an option where the strike price is out of the money.
For example EUR/USD is trading at 1.1500. It will be very expensive to buy an option to buy at 1.1000 while there will be a much smaller premium to buy an option to buy at 1.2000.

FX Option strategies

Contrarian view

Options can be particularly profitable for traders who tend to hold contrarian views. If there is one-sided sentiment within markets and low volatility, option positions are likely to provide value and pricing should also be relatively attractive, especially for out-of-the-money options. In particular, if a currency looks to be significantly undervalued, there is scope for buying call options on expectations that the currency will strengthen over time.

Speculative gains

Options can be used an instrument to make speculative gains, especially when there looks to be scope for a substantial currency move.

There is an up-front cost to buying the option, but this cost is known and there is no further cost if the market moves against you.

Example

A trader believes that President Trump will be impeached and the dollar will decline sharply, possibly as far as the 100.00 level. In this case, an option can be bought to sell USD/JPY at 115.00. There will be a substantial profit if the dollar declines sharply while it will expire as worthless if the dollar strengthens.


Note: all graphs are taken from TradingView – https://www.tradingview.com/

Hedging protection

An important use for options is a hedging instrument to protect against adverse currency moves, especially in the corporate sector.

If substantial revenue is expected in an overseas currency an option can be used to protect the company from any currency losses. This is particularly important to protect profit margins on large contracts.

In effect, the option premium can be seen as a cost in the contract. If the market moves in your favour by the time revenue is received, the option will be abandoned with a profit made on the spot market move.

If, however, the exchange rate moves against you, the option can be exercised to protect revenue.

Options can be used as an alternative to a forward rate and they are particularly attractive if there is uncertainty surrounding the revenue stream.  If a company takes out a forward contract and the expected revenue does not materialise, there is a potentially substantial cost if the market has moved against the company.

Example

A UK company has ordered machinery from Japan and will have to pay CHF0.5mn in August 2019. The company is concerned that the Swiss franc will strengthen from the spot rate of 1.2800 by the time the payment is due.

The company can, therefore, buy an option to sell 0.5mn of GBP/CHF at 1.2800 for August 2019.

If by that date GBP/CHF has declined sharply, the option will be exercised. If Sterling has strengthened, the option will not be exercised and the payment in Sterling terms will be lower.

It is important to note that there is always an element of taking a market view when using options which can be dangerous and a distraction from the business.


Note: all graphs are taken from TradingView – https://www.tradingview.com/

Managing big events

Options can be used to trade large binary events and it is particularly attractive if substantial market moves are expected. Pricing will be more attractive if there is an element of complacency in markets which is keeping volatility low.

A notable case in the short term is the UK Brexit debate and uncertainty surrounding the outcome. Sterling has the potential for a substantial move and heavy losses if the UK exits the EU in March 2019 without securing an exit deal. In contrast, the ability to secure a deal could trigger significant Sterling gains.

In this situation, options can be used to protect income and potentially make speculative gains.

If you believe a deal is likely and Sterling is set to strengthen, there is scope to buy an option to sell EUR/GBP at 0.9000. This would be particularly attractive in the case of an exporter receiving Euros given the need to protect export revenue.

If you believe there will be acrimonious failure and a Sterling slide, there is scope for buying an option to buy EUR/GBP at 0.9000 and above.


Note: all graphs are taken from TradingView – https://www.tradingview.com/

Hedging and speculation

Companies and individuals may look to combine hedging and speculation at the same time. The easiest way to achieve this is to take a larger option position than is necessary to protect commercial interests.

Example

A German company expects revenue from the US of $200,000 to be received in June 2019. The company is anxious to protect against the risk of a stronger Euro and its central position is that the Euro will strengthen.

An option position could be taken to buy EUR/USD at 1.1500 for $250,000 amid expectations that the Euro will strengthen to 1.2500.  The company has, therefore, protected its expected income and will secure a windfall gain if the Euro does strengthen.

 

Note: all graphs are taken from TradingView – https://www.tradingview.com/

Concluding Thoughts on FX Options

FX options could be a useful tool to hedge a business’ future currency requirements. In comparison to Forward Contracts, the level of risk is increased as options may expire at a loss, while with Forward Rates the price is constant and set. With additional risk, comes additional reward, and options can be served to speculate and benefit from currency movements that go in the “right” direction. We, however, would strongly recommend to minimise the usage of FX options as a hedging tool because FX rates and events, as binary as they may be, are difficult to predict.

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